You plan to invest in one of two home delivery pizza companies, High and Low, th

Question

You plan to invest in one of two home delivery pizza companies, High and Low, that were recently founded and are about to commence operations. They are identical except for their use of debt (wd) and the interest rates on their debt--High uses more debt and thus must pay a higher interest rate. Based on the data given below, how much higher or lower will High's expected EPS be versus that of Low, i.e., what is EPSHigh - EPSLow?

Applicable to Both Firms      Firm High's Data         Firm Low's Data                          

Capital       $3,000,000         wd                70%         wd             20%

EBIT            $500,000           Shares         90,000      Shares     240,000

Tax rate             35%            Int. rate         12%         Int. rate      10%

a. $0.49

b. $0.54

c. $0.60

d. $0.66

e. $0.73

Explanation / Answer

Answer:

Firm's High:

Debt = 3000,000 * 70/100 = $ 21,00,000

Interest On Debt = 12/100*21,00,000= $ 252,000

So, EBT= EBIT - Interest = 500000 -252000 =248000,

EPS = EAT(earning after taxes) / No. of shares

= 248000(1-0.35) / 90000 = 161200 / 90000 = 1.79(Appros) per share

Firm's LOw:

Debt = 3000,000 * 20/100 = $ 6,00,000

Interest On Debt = 10/100*600,000= $ 60,000

So, EBT= EBIT - Interest = 500000 -60000 =440000,

EPS = EAT(earning after taxes) / No. of shares

= 440000(1-0.35) / 240000 = 286000 / 240000 = 1.19(ApproX) per share

Therefore,

EPSHIgh - EPS low

= 1.79 - 1.19 = $0.60 per share

So, Answer should be (C) 0.60$.

THanks

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