Question

Lenow Drug Stores and Hall Pharmaceuticals are competitors in the discount drug chain store business. The separate capital structures for Lenow and Hall are presented here. Lenow Debt @ 10% Common stock, $10 par Total Common shares Hall $140,000 Debt @ 10% 280,000 Common stock, $10 par $420,000 Total 28,000 Common shares $ 280,000 140,000 $420,000 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.) What is the relationship between the EPS of the two firms? EBIT/TA % Lenow EPS Hall EPS $ $ $ EBIT 18,000 42,000 59,000 Total Assets $ 420,000 $ 420,000 $ 420,000 b-1. What is the EBIT/TA rate when the firm's have equal EPS? EBIT/TA rate %

Answer 1

rate positively ..

Answer a.
	i	ii	iii=i/ii
	EBIT	Total asset	EBIT/TA	Lenow EPS	Hall EPS	relationship
	18000	420000	4.29%	0.10	(0.50)	Pretax return is lower than cost of debt therefore Hall EPS is lower compared to Lenow
	42000	420000	10.00%	0.70	0.70	Pretax retun is equal to the cost of debt therefore both EPS are equal
	59000	420000	14.05%	1.13	1.55	pretax return is higher than cost of debt therefore Lenow EPS is lower than Hall EPS
	Computation of EPS
		Lenow				Hall
i	EBIT	18000	42000	59000		18000	42000	59000
ii	interest	14000	14000	14000		28000	28000	28000
iii=i-ii	EBT	4000	28000	45000		-10000	14000	31000
iv=iii*.9	PAT=EBT*(1-0.3)	2800	19600	31500		-7000	9800	21700
v	Share out standing	28000	28000	28000		14000	14000	14000
vi=iv/v	EPS	0.10	0.70	1.13		(0.50)	0.70	1.55
Answer b.-1
	at 10% EBIT/TA both the firm has equal EPS $0.7 per share
Answer b.-2
	Cost of debt =10%
Answer b.-3
	EPS is unaffected by financial leverage when the pre tax retun on asset (EBIT/TA) is equal to the cost of debt
Answer c
	Break even level if debt cost incresed to 12%
	At break even (with 12% cost of debt) we should have EBIT/TA = 12%
	EBIT = 12%* TA
	EBIT =	12%*420000
	EBIT =	50400
	Breakeven EBIT =	50400