Question

Lenow’s Drug Stores and Hall’s Pharmaceuticals are competitors in the discount drug chain store business. The separate capital structures for Lenow and Hall are presented here.

Lenow				Hall
Debt @ 10%	$	140,000		Debt @ 10%	$	280,000
Common stock, $10 par		280,000		Common stock, $10 par		140,000
Total	$	420,000		Total	$	420,000
Common shares		28,000		Common shares		14,000

a. Complete the following table given earnings before interest and taxes of $18,000, $42,000, and $59,000. Assume the tax rate is 30 percent. (Negative amounts should be indicated by parentheses or a minus sign. Round your answers to 2 decimal places.)
EBIT Total Assets EBIT/TA Lenow EPS Hall EPS the EPS of the two firms?

$18,000 $420,000 ______ % ________ _______ ______________

$42,000 $420,000 10.00 % ________ ________ _______________

$59,000 $420,000 ______ % _________ _________ _______________

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

EBIT/TA _____rate %

b-2. What is the cost of debt?
  

Cost of debt %

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

EPS is unaffected by financial leverage when the pre-tax return on assets (EBIT/TA) _______ the cost of debt

c. If the cost of debt went up to 12 percent and all other factors remained equal, what would be the break-even level for EBIT?
  

Break-even level

Answer 1

a.

		Lenow’s Drug Stores	Hall’s Pharmaceuticals
1.	earnings before interest and tax	18000	18000
	less: interest	14000	28000
	Earning before tax	4000	-10000
	less: Tax@30%	1200	3000
	Earning after tax	2800	-7000
	EPS [Earning after tax /Common shares ]	0.1	-0.5	Lenow EPS > Hall EPS
2.	Earnings before interest and tax	$42,000	$42,000
	less: interest	14000	28000
	Earning before tax	28000	14000
	less: Tax@30%	8400	4200
	Earning after tax	19600	9800
	EPS [Earning after tax /Common shares]	0.7	0.7	Lenow EPS = Hall EPS
3.	Earnings before interest and tax	59,000	59,000
	less: interest	14000	28000
	Earning before tax	45000	31000
	less: Tax@30%	13500	9300
	Earning after tax	31500	21700
	EPS [Earning after tax /Common shares]	1.13	1.55	Lenow EPS < Hall EPS

b-1. EBIT/TA =10%(cost of debt) , then the firm' will have equal EPS

b-2   Cost of debt =  10%

b-3. EPS is unaffected by financial leverage when the pre-tax return on assets (EBIT/TA) equals the cost of debt

c. EBIT/TA =cost of debt

EBIT/$420,000 =0.12

EBIT = 50400