Question

Lenow Drug Stores and Hall 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% $ 270,000 Debt @ 8% $ 540,000 Common stock, $10 par 540,000 Common stock, $10 par 270,000 Total $ 810,000 Total $ 810,000 Common shares 54,000 Common shares 27,000 a. Complete the following table given earnings before interest and taxes of $31,000, $64,800, and $81,000. Assume the tax rate is 10 percent.

	What is the relationship between EBIT Total Assets EBIT/TA % Lenow EPS Hall EPS the EPS of the two firms? $31,000 $810,000 % $64,800 $810,000 % $81,000 $810,000 %

What is the EBIT/TA rate when the firm's have equal EPS? What is the cost of debt? State the relationship between earnings per share and the level of EBIT. 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?

Answer 1

Given,

	Lenow	Hall
Debt @ 8%	270,000	540,000
Common stock, $10 par	540,000	270,000
Total	810,000	810,000
Common shares	54,000	27,000

EBIT	Total Assets	EBIT/TA
$31,000	$810,000	= $31,000/$810,000 = 0.0382 = 3.82%
$64,800	$810,000	= $64,800/$810,000 = 0.08 = 8%
$81,000	$810,000	= $81,000/$810,000 = 0.1 = 10%

EPS = EAT/ Common Shares

EBIT	Interest	EBT	Tax@10%	EAT	Lenow EPS
$31,000	= $270,000 * 8% = $21,600	$9,400	$940	$8,460	= $8,460/ 54,000 = $0.1566
$64,800	$21,600	$43,200	$4,320	$38,880	= $38,880/ 54,000 = $0.7185
$81,000	$21,600	$59,400	$5,940	$53,460	= $53,460/ 54,000 = $0.99

EBIT	Interset	EBT	Tax@10%	EAT	Hall EPS
$31,000	= $540,000 * 8% = $43,200	-$12,200	-$1,220	-$10,980	= -$10,980/ 27,000 = -$0.4066
$64,800	$43,200	$21,600	$2,160	$19,440	= $19,440/ 27,000 = $0.72
$81,000	$43,200	$37,800	$3,780	$34,020	= $34,020/ 27,000 = $1.26

The relationship between EPS of two firms is, if the EBIT is at $64,800 point then the EPS of the both firms is almost equal. And if the EBIT at $31,000 point then the Lenow EPS is just above the 0 but Hall EPS was negative. If the EPS is at $81,000 point then Lenow EPS is just below the 1 but the Hall EPS was above 1. So it means to say that Lenow EPS was between 0 and 1 and Hall EPS was from less than 0 to more than 1.

At EBIT of $64,800 point both firms have the same EPS, so at that level EBIT/TA is 8%.