Company D is comparing two different capital structures: an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, the company would have 160,000 shares of stock outstanding. Under Plan II, there would be 80,000 shares of stock outstanding and $3million in debt outstanding. The interest rate on the debt is 5%, and there are no taxes. (a)If EBIT is $300,000, which plan will result in the higher EPS? (b)If EBIT is $500,000, which plan will result in the higher EPS? (c)What is the break-even EBIT?
a) |
Plan 1 |
EPS = EBIT*(1-tax rate)/shares = 300000*(1-0)/160000=1.88 |
Plan 2 |
EPS = (EBIT-debt*interest rate)*(1-tax rate)/shares = (300000-3000000*0.05)*(1-0)/80000=1.88 |
both have same EPS
b) |
Plan 1 |
EPS = EBIT*(1-tax rate)/shares = 500000*(1-0)/160000=3.13 |
Plan 2 |
EPS = (EBIT-debt*interest rate)*(1-tax rate)/shares = (500000-3000000*0.05)*(1-0)/80000=4.38 |
Plan 2 has higher EPS
c)Break even EBIT is the EBIT where EPS plan I = EPS plan II |
EBIT*(1-tax rate)/shares = (EBIT-interest rate*debt)*(1-tax rate)/shares |
EBIT*(1-0)/160000=(EBIT-0.05*3000000)*(1-0)/80000 |
EBIT =300000 |
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