Question

1.   Wagner Industries is comparing two different capital structures. Plan I would result in 9,500 shares of stock and $361,000 in debt. Plan II would result in 12,000 shares of stock and $238,000 in debt. The interest rate on the debt is 10 percent.

a.         Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $71,000. The all-equity plan would result in 19,000 shares of stock outstanding. Which of these three plans has the highest EPS? The lowest?

b.         In question (1), what are the break-even levels of EBIT for each plan as compared to that for an all-equity plan? Is one higher than the other? Why?

c.         Ignoring taxes, when will EPS be identical for Plans I and II?

Answer 1

Answer (a):

Plan II has highest EPS

Plan I has lowest EPS

Workings:

Answer b.

Break-even levels of EBIT for Plan I as compared to that for an all-equity plan:

=> 71000 / 19000 = (EBIT - 361000 * 10%) / 9500

EBIT = $71,600

Break-even levels of EBIT for Plan I as compared to that for an all-equity plan = $71,600

Break-even levels of EBIT for Plan II as compared to that for an all-equity plan:

=> 71000 / 19000 = (EBIT - 238000 * 10%) / 12000

EBIT = $68,642

Break-even levels of EBIT for Plan II as compared to that for an all-equity plan = $68,642

Yes, one is higher than the other.

Plan I has higher leverage than Plan II.

Answer c:

The EBIT at which level EPS of both Plan I and Plan II will be identical:

=> (EBIT - 361000 * 10%) /9500 = (EBIT - 238000 * 10%) / 12000

=> EBIT = $82,840

EPS be identical for Plans I and II when EBIT = $82,840