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%	$	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.)

	What is the relationship between EBIT Total Assets EBIT/TA % Lenow EPS Hall EPS the EPS of the two firms? $34,000 $900,000 % $72,000 $900,000 % $89,000 $900,000 %

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

b-2. What is the cost of debt?
  

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

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?
  

Answer 1

ANSWER

a)						What is the relationship
	EBIT	Total Assets	EBIT/TA	Lenow EPS	Hall EPS	of the two firms
	34000	900000	3.78%	$          0.15	$ -0.47	Lenow > Hall
	72000	900000	8.00%	$          0.72	$ 0.72	Lenow = Hall
	89000	900000	9.89%	$          0.98	$ 1.23	Lenow < Hall
	CALCULATION OF EPS:
	LENOW:
	EBIT	Interest	EBT	Tax at 10%	NI	# of shares	EPS
	34000	24000	10000	1000	9000	60000	$              0.15
	72000	24000	48000	4800	43200	60000	$              0.72
	89000	24000	65000	6500	58500	60000	$              0.98
	HALL:
	EBIT	Interest	EBT	Tax at 10%	NI	# of shares	EPS
	34000	48000	-14000	0	-14000	30000	$             -0.47
	72000	48000	24000	2400	21600	30000	$              0.72
	89000	48000	41000	4100	36900	30000	$              1.23
b-1)	EBIT/TA rate for equal EPS = 8%
b-2)	Cost of debt = 8%
b-3)	EPS is unaffected by financial leverage when the pre-tax returns on assets (EBIT/TA) equals the cost of debt.
c)	Breakeven EBIT is where the EPS of the two firms are equal.
	EPS for Lenow = (E-24000)*90%/60000
	EPS for Hall = (E-48000)*90%/30000
	where E = the break even EBIT
	Equating the two EPS
	(E-24000)*90%/60000 = (E-48000)*90%/30000
	Solving for E
	(E-24000) = 2*(E-48000)
	E-24000 = 2*E - 96000
	E = 72000
	Breakeven EBIT = $24000
	CHECK:
			Lenow	Hall
	EBIT		72000	72000
	Interest		24000	48000
	EBT		48000	24000
	Tax at 10%		4800	2400
	NI		43200	21600
	# of shares		60000	30000
	EPS		$           0.72	$          0.72

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