Question

Bebe Metals is planning a major expansion program requiring $10,000,000 in financing. Bebe’s may sell bonds with a 6% coupon rate or sell 200,000 shares of common stock to get the needed funds. After the expansion there is a 50% probability of EBIT (Earnings Before Interest and Taxes) being $5 million, a 20% probability of it being $3 million and a 30% probability of it being $4 million. The following data was taken from the firm’s pre-expansion income statement:

Interest expense                                 $200,000

Tax Rate                                              40%

Common shares outstanding             350,000

Calculate the EPS based on the expected EBIT under each alternative.

Which plan would you chose at this level of EBIT?

Compute the DFL (Degree of Financial Leverage) at the expected level of EBIT under each financing alternative. If EBIT increased by 10%, what would the new EPS be under each alternative?

Answer 1

1. EPS based on expected EBIT under each alternative method.
Expected EBIT after expansion -
		(Amount in $)
Profit	Probablity	Expected profit
(A)	(B)	(A*B)
50,00,000	0.5	25,00,000
30,00,000	0.2	6,00,000
40,00,000	0.3	12,00,000
	EBIT	43,00,000
Calculation of EPS under both alternatives
		(Amount in $)
	Alternative 1	Alternative 2
Expected EBIT	43,00,000	43,00,000
less : Intetest expense	2,00,000	2,00,000
Less: Interest on Bonds (10,000,000 * .08)	8,00,000	-
	33,00,000	41,00,000
Less : Tax @ 40%	13,20,000	16,40,000
Profit After tax (A)	19,80,000	24,60,000
Existing no. of shares	3,50,000	3,50,000
New shares	-	2,00,000
Total number of shares (B)	3,50,000	5,50,000
EPS (A/B)	5.66	4.47
2. Based on EPS, Alternative one of issuing of Bonds is Prefereable.
3. Degree of Financial leverage = EBIT/(EBIT - Interest)
		(Amount in $)
	Alternative 1	Alternative 2
EBIT (A)	43,00,000	43,00,000
Interest (B)	10,00,000	2,00,000
EBIT - Interest {C = A-B}	33,00,000	41,00,000
Degree of Financial leverage (A/C)	1.30	1.05
4. Revised expected EPS, If EBIT increased by 10%
(Amount in $)
Revised EBIT (43,00,000*1.1)		47,30,000
	Alternative 1	Alternative 2
Expected EBIT	47,30,000	47,30,000
less : Intetest expense	2,00,000	2,00,000
Less: Interest on Bonds (10,000,000 * .08)	8,00,000	-
	37,30,000	45,30,000
Less : Tax @ 40%	14,92,000	18,12,000
Profit After tax (A)	22,38,000	27,18,000
Existing no. of shares	3,50,000	3,50,000
New shares	-	2,00,000
Total number of shares (B)	3,50,000	5,50,000
EPS (A/B)	6.39	4.94