Question

The Lopez-Portillo Company has $12 million in assets, 60 percent financed by debt and 40 percent financed by common stock. The interest rate on the debt is 12 percent and the par value of the stock is $10 per share. President Lopez-Portillo is considering two financing plans for an expansion to $25 million in assets. Under Plan A, the debt-to-total-assets ratio will be maintained, but new debt will cost a whopping 15 percent! Under Plan B, only new common stock at $10 per share will be issued. The tax rate is 35 percent. a. If EBIT is 13 percent on total assets, compute earnings per share (EPS) before the expansion and under the two alternatives. (Round your answers to 2 decimal places.) Earnings per Share Current Plan A Plan B

Answer 1

Particulars Total Assets Debt Formula Given Current 1,20,00,000 Plan A 2,50,00,000 Plan B 2,50,00,000 - Exisiting debt Existing total assets (12m)*60% 7,200,000 (i.e. 12m*60%) 7,200,000 (i.e. 12m*60%) 7,200,000 (i.e. 12m*60%) 7,800,000 [i.e. (25m-12m)*60%] 1,50,00,000 Plan A: (Increased assets-existing assets)*60% Existing debt + New debt - New debt - Total debt 72,00,000 72,00,000 Equity - Exisiting equity Existing total assets (12m)*40% 4,800,000 (i.e. 12m*40%) 4,800,000 (i.e. 12m*40%) 4,800,000 (i.e. 12m*40%) - New equity Plan A: (Increased assets-existing assets)*40% Plan B: (Increased assets-existing assets)* 100% Existing equity + New equity 5,200,000 [i.e. (25m-12m)*40%] 13,000,000 [i.e. (25m-12m)*100%] - Total equity 48,00,000 1,00,00,000 1,78,00,000 No. of shares Total equity in USD/$10 per share 4,80,000 (i.e. 4,800,000/10) 10,00,000 (i.e. 10,000,000/10) 17,80,000 (i.e. 17,800,000/10)

EBIT Total Assets *13% (i.e. 12m*13%; 25m*13%; 25m*13%) 15,60,000 32,50,000 32,50,000 Interest - Exisiting interest Existing debt@12% 8,64,000 (i.e. 7,200,000*12%) 8,64,000 (i.e. 7,200,000*12%) - New interest New debt@15% 8,64,000 (i.e. 7,200,000*12%) 11,70,000 (i.e. 7,800,000*15%) 20,34,000.0 12,16,000.00 4,25,600.00 7,90,400.00 - Total interest Earnings before taxes (EBT) Taxes Earnings after taxes Existing interest + New interest EBIT-total interest EBT*35% EBT-taxes 8,64,000.0 6,96,000.00 2,43,600.00 4,52,400.00 8,64,000.0 23,86,000.00 8,35,100.00 15,50,900.00 a. Earnings per share Earnings after taxes/No. of shares 0.94 (i.e. 4,52,400/4,80,000) 0.79 (i.e. 7,90,400/10,00,000) 0.87 (i.e. 15,50,900/17,80,000) b. Degree of financial leverage EBIT/EBT 2.24 2.67 (i.e. 15,60,000/6,96,000) (i.e. 32,50,000/12,16,000) 1.36 (i.e. 32,50,000/23,86,000) c. EPS if stock sold at $20 per share No. of shares in this scenario - Exisiting no. of shares Existing equity in USD/$10 per share - New no. of shares New equity in USD/$20 per share 4,80,000 (i.e. 4,800,000/10) 2,60,000 (i.e. 5,200,000/20) 7,40,000 1.07 (i.e. 7,90,400/7,40,000) 4,80,000 (i.e. 4,800,000/10) 6,50,000 (i.e. 13,000,000/20) 11,30,000 - Total no. of shares Existing + New 1.37 Earnings per share Earnings after taxes/No. of shares (i.e. 15,50,900/11,30,000)