Question

The Lopez-Portillo Company has $10 million in assets, 80 percent financed by debt and 20 percent...

The Lopez-Portillo Company has $10 million in assets, 80 percent financed by debt and 20 percent financed by common stock. The interest rate on the debt is 15 percent, and the stock book value is $10 per share. President Lopez-Portillo is considering two financing plans for an expansion to $15 million in assets. Under Plan A, the debt-to-total-assets ratio will be maintained, but new debt will cost 18 percent! New stock will be sold at $10 per share. Under Plan B, only new common stock at $10 per share will be issued. The tax rate is 40 percent.

a. If EBIT is 15 percent on total assets, compute earnings per share (EPS) before the expansion (current) and under the two alternatives after expansion. (Round the final answers to 2 decimal places.)

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Answer #1

a) Current plan

Debt = 80% of $10 million assets = $ 8 million @15%

Equity = 20% of $10 million assets = $ 2 million

No. of Shares = $2million /$10per share = 200,000

Annual Interest Charge=15% of $ 8 million = $1,200,000

b) Plan A (same D/E ratio)

Debt = 80% of $15 million assets = $ 12 million ($ 8 million @15% and $4 million @18%)

Equity = 20% of $15 million assets = $ 3 million

No. of Shares = $3million /$10per share = 300,000

Annual Interest Charge=15% of $ 8 million + 18%of $4 million  = $1,920,000

b) Plan B (new assets financed by equity)  

Debt = $ 8 million @15%  

Equity = $15 million -$8 million = $ 7 million

No. of Shares = $7 million /$10 per share = 700,000

Annual Interest Charge=15% of $ 8 million = $1,200,000

The EPS calculations under all three scenarios (Current, Plan A and Plan B) are shown in the table below

All figures in $
Current Plan A Plan B
Debt 8,000,000 12,000,000 8,000,000
Equity 2,000,000 3,000,000 7,000,000
Total Assets 10,000,000 15,000,000 15,000,000
No. of Shares 200,000 300,000 700,000
EBIT 1,500,000 2,250,000 2,250,000
Interest 1,200,000 1,920,000 1,200,000
EBT 300,000 330,000 1,050,000
Tax 120,000 132,000 420,000
EAT 180,000 198,000 630,000
EPS 0.90 0.66 0.90
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