Question

Franklin Corporation is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, the company would have 200,000 shares of stock outstanding. Under Plan II, there would be 150,000 shares of stock outstanding and $2.2 million in debt outstanding. The interest rate on the debt is 5 percent and there are no taxes.

a. If EBIT is $350,000, what is the EPS for each plan? (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)

EPS
Plan I $
Plan II $

b. If EBIT is $600,000, what is the EPS for each plan? (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)

EPS
Plan I $
Plan II $

c. What is the break-even EBIT? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)

Break-even EBIT $

Answer 1

Answer:

a) unlevered: 1.75 EPS

       levered: 1.60 EPS

b)unlevered: 3.00 EPS

       levered: 3.27 EPS

c) EBIT break even point: 440,000 dollars

at this point is indifferent which plan the firm chose.

Explanation:

unlevered firm:

200,000 shares (100%)

levered firm

150,000 shares      (75%)

Debt: $2,200,000  (25%)

a) EBIT: 350,000

unlevered: 350,000/200,000 = 1.75 EPS

levered: (350,000-2,200,000x5%)/150,000 = 1.6 EPS

b) EBIT: 650,000

unlevered: 600,000/200,000 = 3 EPS

levered: (600,000-2,200,000x5%)/150,000 = 3.27 EPS

c) we should build and equation system at which both plans get the same EPS:

$\left \{ {{EPS_u=\frac{EBIT}{200,000} }\\ \atop {EPS_l=\frac{EBIT-interest}{150,000} }} \right.$

We equalize and solve for EBIT:

$\frac{EBIT}{200,000} = \frac{EBIT-interest}{150,000}$

interest is: 2,200,000 x 5% = 110,000

$\frac{EBIT}{200,000} \times 150,000 = EBIT-110,000$

$EBIT \times 0.75 = EBIT-110,000$

$(1 - 0.75)EBIT = 110,000$

$EBIT = 110,000 \div 0.25$

EBIT = 440,000