Question

Loving Gardens has $6 million in assets, $700,000 EBIT, 80,000 shares of stock outstanding, and a marginal tax rate equal to 40 percent. If Loving Garden's debt-to-total-assets (D/TA) ratio is 70 percent, it pays 12 percent interest on debt, whereas if the D/TA ratio is 40 percent, interest is 9 percent. Calculate Loving Gardens EPS and ROE (ROE = Net Income / Equity) for each capital structure. Which capital structure is better?

Answer 1

Please refer to below spreadsheet for calculation and answer. Cell reference also provided.

E F G Total Assets D/TA ratio Debt Equity Interest rate on debt $6,000,000.00 70% $4,200,000.00 $1,800,000.00 12% Total Assets D/TA ratio Debt Equity Interest rate on debt $6,000,000.00 40% $2,400,000.00 $3,600,000.00 9% ūño od von Awn- EBIT Interest EBT Tax (40%) Net Income $700,000.00 $504,000.00 $196,000.00 $78,400.00 $117,600.00 EBIT Interest ЕВТ Tax (40%) Net Income $700,000.00 $216,000.00 $484,000.00 $193,600.00 $290,400.00 Stock outstanding 80,000 Stock outstanding 80,000 Earning per share (EPS) Earning per share (EPS) $1.47 6.53% $3.63 8.07% ROE ROE D/TA=40%, is better option.

Cell reference -

A B C D Total Assets D/TA ratio Debt Equity Interest rate on debt 6000000 0.7 =C2*C3 =C2-C4 0.12 Total Assets D/TA ratio Debt Equity Interest rate on debt 6000000 0.4 =F2*F3 |=F2-F4 0.09 |EBIT Interest 700000 =C4*C6 EBT =C8-C9 |EBIT Interest EBT Tax (40%) Net Income 700000 =F4* F6 =F8-F9 =F10*0.4 =F10-F11 Tax (40%) Net Income =C10*0.4 =C10-C11 Stock outstanding 80000 Stock outstanding 80000 Earning per share (EPS) ROE =C12/C14 =C12/C5 Earning per share (EPS) ROE =F12/F14 =F12/F5 D/TA=40%, is better option.

Please note: It assumed that share outstanding is same for both cases.

Hope this will help, please do comment if you need any further explanation. Your feedback would be highly appreciated.