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%	$ 290,000	Debt @ 10%	$ 580,000
Common stock, $10 par	580,000	Common stock, $10 par	290,000
Total	$ 870,000	Total	$ 870,000
Common shares	58,000	Common shares	29,000

a. Complete the following table given earnings before interest and taxes of $33,000, $87,000, and $88,000. 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.)

						What is the relation ship between
EBIT	Total Assets	EBIT/TA	%	Lenow EPS	Hall EPS	The EPS of the two firms
$33,000	$870,000	3.79	%
$87,000	$870,000	10.00	%
$88,000	$870,000	10.11	%

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 _____%

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)	EBIT	Total Assets	EBIT/TA	%	Lenow EPS	Hall EPS	What is the relationship between the EPS of the two firms
	$         33,000	$      8,70,000	3.79	%	$           0.05	$           -0.60	Lenow EPS>Hall EPS
	$         87,000	$      8,70,000	10.00	%	$           0.70	$             0.70	Leno EPS=Hall EPS
	$         88,000	$      8,70,000	10.11	%	$           0.71	$             0.72	Hall EPS>Lenow EPS
	WORKSHEET:
	LENOW:
	EBIT	Interest	EBT		Tax at 30%	NI	Number of shares	EPS
	$         33,000	$         29,000	$         4,000		$         1,200	$          2,800	58000	$         0.05
	$         87,000	$         29,000	$       58,000		$      17,400	$        40,600	58000	$         0.70
	$         88,000	$         29,000	$       59,000		$      17,700	$        41,300	58000	$         0.71
	HALL:
	$         33,000	$         58,000	$     -25,000		$       -7,500	$      -17,500	29000	$        -0.60
	$         87,000	$         58,000	$       29,000		$         8,700	$        20,300	29000	$         0.70
	$         88,000	$         58,000	$       30,000		$         9,000	$        21,000	29000	$         0.72
b-1)	EBIT/TA rate = 10%.
b-2)	Cost of debt = 10%
b-3)	Break even level of EBIT is that level of EBIT at which EPS is 0 for the two firms.
	EPS for Lenow = (E-34800)*0.7/58000 and
	EPS for Hall = (E-69600)*0.7/29000
	where E = the break even EBIT level.
	Solving for E
	(E-34800)*0.7/58000 = (E-69600)*0.7/29000
	(E-34800) = (E-69600)*2
	E - 34800 = 2*E - 139200
	E = 139200-34800 = 104400
	Break even level of EBIT = $104400.
	CHECK:
	EBIT	Interest	EBT		Tax at 30%	NI	Number of shares	EPS
	$     1,04,400	$         34,800	$       69,600		$      20,880	$        48,720	58000	$         0.84
	HALL:
	$     1,04,400	$         69,600	$       34,800		$      10,440	$        24,360	29000	$         0.84