Question

The Ocean-Store Hypermarket is considering acquiring another of its regional competitor in Terengganu. The Ocean-Store plans to finance the purchase by the sale of common stocks or a debt issue. The company finance manager is required to evaluate how the two alternative financing plans will affect the earnings potential of the company. Total financing required is $20 million. The company tax rate is 40 percent.
The company’s current structure is as follows:
$50,000,000 of 10% bonds (Par value $1,000 per unit)
$10,000,000 shares of common stocks (par value of $1.00 per share)
The company can arrange financing of the $20 million through
Option A: 11 percent bond issue
Option B: The sale of common stock at $10 per share
a) Suppose Ocean-Store is confident of achieving an EBIT of $30 million, under which plan will shareholders get higher income? [Find EPS]
b) What is the DFL for each plan at $30 million EBIT?
c) If EBIT were to drop by 20%, what will be the drop in earnings under each plan? Explain your findings. [Hint: Find breakeven EBIT to explain]

Answer 1

a) EBIT = $30 million

Existing :

Bond = $50 million @ 10%

Common stock = $10 million at $1 (ie 10 million shares)

Tax rate = 40% or 0.40

i) Option A : $20 million bond @ 11%

EPS = Net income / Outstanding shares

Here,

Net income = (EBIT - Interest) * (1 - Tax rate)

Interest = ($50 million * 10%) + ($20 million * 11%)

Interest = $5 million + $2.20 million = $7.20 million

Net income = ($30 million -$7.20 million)*(1 - 0.40)

Net income = $22.80 million * 0.60

Net income = $13.68 million

Now,

EPS = $13.68 million / 10 million shares

EPS = $1.368 per share

ii) Option B : $20 million common stock at $10 per share

Additional common stock = New issue / Price per share

Additional common stock = $20 million / $10 per share = 2 million additional common stock

Total common stock outstanding = 10 million shares + 2 million shares

Total common stock outstanding = 12 million shares outstanding

Net income = (EBIT - Interest) * (1 - Tax rate)

Interest (Existing bond only) = $50 million * 10%

Interest = $5 million

Net income = ($30 million - $5 million) * (1 - 0.40)

Net income = $25 million * 0.60

Net income = $15 million

Now,

EPS = Net income / Outstanding common stock (includes additional stock)

EPS = $15 million / 12 million outstanding stock

EPS = $1.25 per share

Answer : EPS in option A will be higher.

b) Degree of financial leverage (DFL) = EBIT / EBT

i) Option A : EBIT = $30 million

EBT (Earnings before tax) = EBIT - Interest

EBT = $30 million - $7.20 million

EBT = $22.80 million

Now,

DFL = $30 million / $22.80 million

DFL = 1.32

ii) Option B : EBIT = $30 million

EBT = EBIT - Interest

EBT = $30 million - $5 million

EBT = $25 million

Now,

DFL = $30 million / $25 million

DFL = 1.20

c) If EBIT were to drop by 20%,

New EBIT = $30 million - ($30 * 20%)

New EBIT = $24 million

i) Option A = New net income = (EBIT - Interest) * (1 - Tax rate)

New net income = ($24 million - $7.20 million) * (1 - 0.40)

New net income = $16.80 million * 0.60

New net income = $10.08 million

Now,

New EPS = New net income / Outstanding common stock

New EPS = $10.08 / 10 million shares

New EPS = $1.01 per share

ii) Option B = New net income = (EBIT - Interest) * (1 - Tax rate)

New net income = ($24 million - $5 million) * (1 - 0.40)

New net income = $19 million * 0.60

New net income = $11.40 million

Now,

New EPS = Net income / Outstanding common stock

New EPS = $11.40 million / 12 million shares

New EPS = $0.95 per share

EPS decreasing in option B than option A.