Question

Round Hammer 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 180,000 shares of stock outstanding. Under Plan II, there would be 130,000 shares of stock outstanding and $1.8 million in debt outstanding. The interest rate on the debt is 6 percent, and there are no taxes.

a. If EBIT is $225,000, what is the EPS for each plan?

b. If EBIT is $475,000, what is the EPS for each plan?

c. What is the break-even EBIT?

Answer 1

Answer:

a. For plan I: $1.25; For plan II: $0.9

b. For plan I: $2.64; For plan II: $2.82

c. The break even EBIT is $388,800

Explanation:

a. Under Plan I: Net income = EBIT = $225,000 => EPS = Total net income/ shares outstanding = 225,000/180,000 = $1.25;

   Under Plan II: Net income = EBIT - Interest expenses = 225,000 - 1,800,000 x 6% = 117,000 => EPS = EPS = Total net income/ shares outstanding = 117,000/130,000 = $0.9;

b. Under Plan I: Net income = EBIT = $475,000 => EPS = Total net income/ shares outstanding = 475,000/180,000 = $2.64;

   Under Plan II: Net income = EBIT - Interest expenses = 475,000 - 1,800,000 x 6% = 367,000 => EPS = EPS = Total net income/ shares outstanding = 367,000/130,000 = $2.82;

c. Denote the break-even EBIT as x.

At break-even EBIT, EPS will be the same for two structures.

=> x/180,000 = (x - 1,800,000 x 6%)/ 130,000 <=> 13x/18 = x - 108,000 <=> 1,08,000 = 5x/18 <=> x = 108,000 x 18/5 = $388,800.