Question

A firm is considering two financing plans. The first (plan A) is an all-equity plan in which $1 million will be raised by selling stock at $50 per share. Plan B involves financial leverage. The firm will raise $500,000 by issuing bonds with a 10 percent effective interest rate. The remaining $500,000 will be raised by issuing common stock at $50 per share. The tax rate is 40 percent. Find the EBIT level which will result in the same EPS for the two plans.
Refer to the above problem. Using the bottom portion of an income statement, show that the EBIT calculated results in the same EPS for plans A and B.

Answer 1

Answer : The EBIT level which will result in the same EPS for the two plans: $ 100,000

Let the break-even EBIT be E.

EPS for Plan A = E x 0.60 / 20,000 shares

EPS for Plan B = ( E - 50,000 ) x 0.60 / 10,000

At the EBIT level where EPS would be the same for the two plans,

0.60 E / 20,000 = ( 0.60 E - 30,000) / 10,000

or 0.6 E = 1.20 E - 60,000

or E = $ 100,000