Question

Break-Even EBIT and Leverage Coldstream Corp. is comparing two different capital structures. Plan I would result in 3,700 shares of stock and $13,700 in debt. Plan II would result in 3,100 shares of stock and $30,140 in debt. The interest rate on the debt is 7 percent. a. Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $7,600. The all-equity plan would result in 4,200 shares of stock outstanding. Which of the three plans has the highest EPS? The lowest? b. In part (a), what are the break-even levels of EBIT for each plan as compared to that for an all- equity plan? Is one higher than the other? Why? c. Ignoring taxes, when will EPS be identical for Plans I and II? d. Repeat parts (a), (b), and (c) assuming that the corporate tax rate is 40 percent. Are the break- even levels of EBIT different from before? Why or why not?

Answer 1

Answer a.

All-equity Plan:

Number of shares outstanding = 4,200

Plan I:

Number of shares outstanding = 3,700
Value of Debt = $13,700

Interest Expense = 7% * $13,700
Interest Expense = $959

Plan II:

Number of shares outstanding = 3,100
Value of Debt = $30,140

Interest Expense = 7% * $30,140
Interest Expense = $2,109.80

All Equity 7,600.00 EBIT $ $ $ Plan 7,600.00 $ 959.00 $ 6,641.00 $ Plan II 7,600.00 2,109.80 5,490.20 $ 7,600.00 Less: Interest Expense EBT Less: Income Taxes Net Income # of Shares EPS $ 7,600.00 $ 4,200 1.81 $ 6,641.00 $ 3,700 1.79$ 5,490.20 3,100 1.77 $

Highest EPS = $1.81
Lowest EPS = $1.77

Answer b.

Let Breakeven EBIT be $x

All-equity Plan:

EPS = (EBIT - Interest Expense) / Number of shares outstanding
EPS = ($x - $0) / 4,200

Plan I:

EPS = (EBIT - Interest Expense) / Number of shares outstanding
EPS = ($x - $959) / 3,700

Plan II:

EPS = (EBIT - Interest Expense) / Number of shares outstanding
EPS = ($x - $2,109.80) / 3,100

Plan I and All-equity Plan:

EPS under Plan I and EPS under All-equity Plan
($x - $959) / 3,700 = ($x - $0) / 4,200
42 * $x - $40,278 = 37 * $x
$x = $8,055.60

Breakeven EBIT is $8,055.60

Plan II and All-equity Plan:

EPS under Plan II and EPS under All-equity Plan
($x - $2,109.80) / 3,100 = ($x - $0) / 4,200
42 * $x - $88,611.60 = 31 * $x
11 * $x = $88,611.60
$x = $8,055.60

Breakeven EBIT is $8,055.60

Answer c.

Plan I and Plan II:

EPS under Plan I and EPS under Plan II
($x - $959) / 3,700 = ($x - $2,109.80) / 3,100
31 * $x - $29,729 = 37 * $x - $78,062.60
$x = $8,055.60

Breakeven EBIT is $8,055.60

Answer d-1.

Less: Interest Expense EBT Less: Income Taxes Net Income # of Shares EPS All Equity $ 7,600.00 $ $ $ $ 7,600.00 $ $ 3,040.00 $ $ 4,560.00 $ 4,200 $ 1.09 $ Plan 7,600.00 $ 959.00 $ 6,641.00 $ 2,656.40 $ 3,984.60$ 3,700 1.08 $ Plan II 7,600.00 2,109.80 5,490.20 2,196.08 3,294.12 3,100 1.06

Answer d-2.

Let Breakeven EBIT be $x

All-equity Plan:

EPS = (EBIT - Interest Expense) * (1 - Tax Rate) / Number of shares outstanding
EPS = ($x - $0) * (1 - 0.40) / 4,200

Plan I:

EPS = (EBIT - Interest Expense) * (1 - Tax Rate) / Number of shares outstanding
EPS = ($x - $959) * (1 - 0.40) / 3,700

Plan II:

EPS = (EBIT - Interest Expense) * (1 - Tax Rate) / Number of shares outstanding
EPS = ($x - $2,109.80) * (1 - 0.40) / 3,100

Plan I and All-equity Plan:

EPS under Plan I and EPS under All-equity Plan
($x - $959) * 0.60 / 3,700 = ($x - $0) * 0.60 / 4,200
42 * $x - $40,278 = 37 * $x
$x = $8,055.60

Breakeven EBIT is $8,055.60

Plan II and All-equity Plan:

EPS under Plan II and EPS under All-equity Plan
($x - $2,109.80) * 0.60 / 3,100 = ($x - $0) * 0.60 / 4,200
42 * $x - $88,611.60 = 31 * $x
11 * $x = $88,611.60
$x = $8,055.60

Breakeven EBIT is $8,055.60

Answer d-3.

Plan I and Plan II:

EPS under Plan I and EPS under Plan II
($x - $959) * 0.60 / 3,700 = ($x - $2,109.80) * 0.60 / 3,100
31 * $x - $29,729 = 37 * $x - $78,062.60
$x = $8,055.60

Breakeven EBIT is $8,055.60