Question

Lenow’s Drug Stores and Hall’s Pharmaceuticals are competitors in the discount drug chain store business. The separate capital structures for Lenow and Hall are presented here.

Lenow				Hall
Debt @ 8%	$	300,000		Debt @ 8%	$	600,000
Common stock, $10 par		600,000		Common stock, $10 par		300,000
Total	$	900,000		Total	$	900,000
Common shares		60,000		Common shares		30,000

a. Complete the following table given earnings before interest and taxes of $34,000, $72,000, and $89,000. Assume the tax rate is 10 percent. (Negative amounts should be indicated by parentheses or a minus sign. Round your answers to 2 decimal places.)
  

b-1. What is the EBIT/TA rate when the firm's have equal EPS?

EBIT/TA rate %

b-2. What is the cost of debt?
  

Cost of debt %

b-3. State the relationship between earnings per share and the level of EBIT.
  

EPS is unaffected by financial leverage when the pretax return on assets (EBIT/TA)

c. If the cost of debt went up to 10 percent and all other factors remained equal, what would be the break-even level for EBIT?
  

Break-even level:

Answer 1

Please rate..

Answer a.
	i	ii	iii=i/ii
	EBIT	Total asset	EBIT/TA	Lenow EPS	Hall EPS
	34000	900000	3.78%	0.15	(0.42)
	72000	900000	8.00%	0.72	0.72
	89000	900000	9.89%	0.98	1.23
	Computation of EPS
		Lenow				Hall
i	EBIT	34000	72000	89000		34000	72000	89000
ii	interest	24000	24000	24000		48000	48000	48000
iii=i-ii	EBT	10000	48000	65000		-14000	24000	41000
iv=iii*.9	PAT=EBT*(1-0.1)	9000	43200	58500		-12600	21600	36900
v	Share out standing	60000	60000	60000		30000	30000	30000
vi=iv/v	EPS	0.15	0.72	0.98		(0.42)	0.72	1.23
Answer b.-1
	at 8% EBIT/TA both the firm has equal EPS $0.71 per share
Answer b.-2
	Cost of debt =8%
Answer b.-3
	relationship
	Pretax return is lower than cost of debt therefore Hall EPS is lower compared to Lenow
	Pretax return is equal to the cost of debt therefore both EPS are equal
	pretax return is higher than cost of debt therefore Lenow EPS is lower than Hall EPS
	Therefore EPS is unaffected when cost of debt = EBIT/TA =8%
Answer c
	Break even level if debt cost increased to 10%
	At break even (with 10% cost of debt) we should have EBIT/TA = 10%
	EBIT = 10%* TA
	EBIT =	10%*900000
	EBIT =	90000
	Breakeven EBIT =	90000