Question

Delcy Incorporated operates out of Guam Island, but is currently experiencing financial shocks due the Covid 19 pandemic plaguing the world. As a strategy to deal with the financial fallouts associated with this pandemic, Delcy   is exploring two possible capital structures as follows;

• Capital Structure 1 - 40,000 shares with $540,000 in debt.
• Capital structure 2 – 30,400 shares with $1,188,000 in debt.

. Delcy’s current interest rate on debts and other loans are 8%.

2-     What are the breakeven levels of EBIT for each plan   as per part, as compared to the all equity plan? Discuss your answer.  

3-     When will EPS be identical for Capital structure 1 and 2?   

4-     Repeat items 1, 2 and 3 assuming a tax rate of 40%. Are the breakeven levels of EBIT different from before? Explain you answer.  

Answer 1

2. Capital Structure 1 v. All Equity Plan.

The breakeven level of EBIT is the level which gives an EPS is identical for both plans.

Let the break-even EBIT level be E.

EPS = ( EBIT - Interest Expense - Taxes ) / Common Shares Outstanding.

EPS for Capital Structure 1 = ( E - 43,200 - 0 ) / 40,000.

EPS for All Equity Plan = ( E - 0 - 0 ) / 48,000

Therefore, ( E - 43,200 ) / 40,000 = E / 48,000

or E = $ 259,200

Capital Structure 2 v. All Equity Plan :

EPS for Capital Structure 2 = ( E - 95,040 - 0 ) / 30,400

At break-even,

( E - 95,040 ) / 30,400 = E / 48,000

or E = $ 259,200.

3. Let the EBIT level be E.

	Capital Structure 1	Capital Structure 2
EBIT	E	E
Less: Interest Expense	43,200	95,040
Earning before Taxes	( E - 43,200 )	( E - 95,040)
Less: Taxes	0	0
Net Income	( E - 43,200)	( E - 95,040)
Common Shares Outstanding	40,000	30,400
EPS	( E - 43,200 ) / 40,000	( E - 95,040) / 30,400

At breakeven,

( E - 43,200 ) / 40,000 = ( E - 95,040) / 30,400

or E = $ 259,200

4. If tax rate is 40 %:

	All Equity Plan	Capital Structure 1	Capital Structure 2
EBIT	E	E	E
Less: Interest Expense	0	$ 43,200	$ 95,040
Earnings before Taxes	E	( E - 43,200)	( E - 95,040)
Less: Taxes @ 40 %	0.40 E	( E - 43,200) x 0.40	( E - 95,040) x 0.40
Net Income	0.6 E	0.6 E - 25,920	0.4 E - 57,024
Common Shares Outstanding	48,000	40,000	30,400
EPS	0.6 E / 48,000	( 0.6 E - 25,920) / 40,000	( 0.6 E - 57,024 ) / 30,400

Break-even between Capital Structure 1 & All Equity Plan:

( 0.6 E - 25,920) / 40,000 = 0.6 E / 48,000

0.72 E - 31,104 = 0.6 E

or E = $ 259,200

Break-even between Capital Structure 2 & All Equity Plan :

( 0.6 E - 57,024) / 30,400 = 0.6 E / 48,000

28,800 E - 2,737,152,000 = 18,240 E

or E = $ 259,200