Question

West Wells is considering opening a new branch. The company expects the new branch’s EBIT to be $10 million per year. At this time, the company is considering the following two financing plans:

• Plan 1: Equity financing. Under this plan, 3 million common shares will be sold at $12 each.
• Plan 2: Debt-equity financing. Under this plan, $20 million of 12 percent long-term debt and 1.6 million common shares at $10 each will be sold.

Use a 40 percent marginal tax rate in your analysis and calculate the EBIT-EPS indifference point.

Answer 1

EBIT EPS indifference point is the point of EBIT at which EPS is same for two different capital structure.

According to this the indifference point would be,

[(EBIT)*(1-Tax rate)]/No. of Shares {Plan 1} = [(EBIT - Interest)*(1-Tax rate)]/No. of Shares {Plan 2}

[EBIT*(1-0.4)]/3 million = [(EBIT - 20 million*12%)*(1-0.4)]/1.6 million

In millions, 0.6 EBIT / 3 = [0.6 EBIT - 1.44 ]/1.6

0.96 EBIT = 1.8 EBIT - 4.32

0.84 EBIT = 4.32

EBIT = 4.32/08.4 = $5.14 Million

At the given level of expected EBIT 10 Million, EPS under both the plans would be,

Plan 1 = EBIT ( 1 - Tax) / No, of Shares = 10(1-04)/3 = $2 per share

Plan 2 = [(EBIT - Interest)*(1-Tax rate)]/No. of Shares = [(10-20*12%)*(1-0.4)]/1.6 = $2.85 per share