Contrail Air, Inc., is looking at two capital structures. Plan A is an all equit

Question

Contrail Air, Inc., is looking at two capital structures. Plan A is an all equity with 500,000 shares outstanding Plan B is a levered plan with 320,000 shares outstanding and debt of $3,467,000 outstanding. The interest rate on the debt is 8 percent, and there are no taxes. 1. If EBIT is $500,000, which plan will result in the higher EPS? 2. If EBIT is $800,000, which plan will result in the higher EPS? 3. What is the break-even EBIT? Input Area: Plan I Shares outstanding 500,000 Plan lI Shares outstanding Debt outstanding Interest rate 320,000 3,476,000 8% a. EBIT b. EBIT 500,000 800,000 Output Area NI EPS Plan l Plan lI b. Plan Plan I C. Breakeven EBIT

Explanation / Answer

1 If EBIT is $500,000 Plan A Plan B EBIT (a) 500000 500000 Interest (b) 0 277360 EAT (c=a-b) 500000 222640 No of shares (d) 500000 320000 EPS (e=c/d) 1.00           0.70 Plan A will result in higher EPS 2 If EBIT is $800,000 Plan A Plan B EBIT (a) 800000 800000 Interest (b) 0 277360 EAT (c=a-b) 800000 522640 No of shares (d) 500000 320000 EPS (e=c/d) 1.60           1.63 Plan B will result in higher EPS c For Break Even EBIT, the investors have to be indifferent between both plans. This will happen when EPS under both plans will be same Forming an equiation based on above statement EBIT/500000= (EBIT-277360)/320000 EBIT*320000/500000) (EBIT-277360) 0.64 EBIT EBIT - 277360 0.36EBIT 277360 EBIT                       770,444.44 Break Even EBIT 770444.44

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