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 @ 9% $250,000 Debt @ 9% $500,000 Common stock, $10 par 500,000 Common stock, $10 par_250,000 Total $750,000 Total 750,000 25,000 Common shares 50,000 Common shares a. Complete the following table given earnings before interest and taxes of $29,000, $67,500, and $73,000. Assume the tax rate is 20 percent. (Negative amounts should be indicated by parentheses or a minus sign. Round your answers to 2 decimal places.) What is the relationship between Total assets Lenow- | EBIT/TAI%) EPS Hall EPS the EPS of th firms? $ 29,000 750,000 S67,500 $ 750,000 $ 73,000 750,000 b-1. What is the EBIT/TA rate when the firm's have equal EPS? EBITITA 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 (EBITITA the cost of debt. equals exceeds is less than c. If the cost of debt went up to 11 percent and all other factors remained equal, what would be the break-even level for EBIT? Break even level

Answer 1

a)						What is the relationship between
	EBIT [$]	Total Assets [$]	EBIT/TA [%]	Lenow EPS	Hall EPS	the EPS of the two firms
	29000	750000	3.87%	0.10	-0.51	Hall EPS < Lenow EPS
	67500	750000	9.00%	0.72	0.72	Hall EPS = Lenow EPS
	73000	750000	9.73%	0.81	0.90	Hall EPS > Lenow EPS
	WORKINGS FOR N & EPS:
	LENOW:
	EBIT [$]	Interest at 9%	EBT	Tax at 20%	NI	# of shares	EPS
	29000	22500	6500	1300	5200	50000	0.10
	67500	22500	45000	9000	36000	50000	0.72
	73000	22500	50500	10100	40400	50000	0.81
	HALL:
	EBIT [$]	Interest at 9%	EBT	Tax at 20%	NI	# of shares	EPS
	29000	45000	-16000	-3200	-12800	25000	-0.51
	67500	45000	22500	4500	18000	25000	0.72
	73000	45000	28000	5600	22400	25000	0.90
b-1)	EBIT/TA rate for equal EPS = 9%
b-2)	Cost of debt = 9%
b-3)	EPS is unaffected by financial leverage when the pre-tax return on assets (EBIT/TA) equals the cost of debt.
c)	Break even level of EBIT is that EBIT level for which EPS = 0
	EPS for Lenow = (E-27500)*0.80/50000
	EPS for Hall = (E-55000)*0.80/25000
	Where E = the break even EBIT.
	Equating the two, we have
	(E-27500)*0.80/50000 = (E-55000)*0.80/25000
	Solving for E
	(E-27500)/50 = (E-55000)/25
	E-27500 = (E-55000)*2
	E-27500 = 2*E-110000
	110000-27500 = E = $82500
	Break even level of EBIT =		82500
	LENOW:
	EBIT [$]	Interest at 11%	EBT	Tax at 20%	NI	# of shares	EPS
	82500	27500	55000	11000	44000	50000	0.88
	HALL:
	EBIT [$]	Interest at 11%	EBT	Tax at 20%	NI	# of shares	EPS
	82500	55000	27500	5500	22000	25000	0.88