Adams Inc. expects EBIT of $50 million if there is a recession, $ 100 million if

Question

Adams Inc. expects EBIT of $50 million if there is a recession, $ 100 million if the economy is normal, and $150 million if the economy expands. Bellingham Inc. also expects EBIT of $50 million if there is a recession, $100 million if the economy is normal, and $150 million if the economy expands. Adams is financed entirely with equity while Bellingham is financed 50% with debt at 10%. Adams has $200 million in equity; Bellingham is financed with $100 million of debt and $ 100 million of equity. The tax rate is 30%. Both firms pay out all available earnings as dividends. If there is a recession, compare dividends and total distributions to investors for each company.

Explanation / Answer

For Adams Inc.

During Recession- EBIT= $50 million

Equity= $200 million

Tax Rate= 30%

Now EAT (Earning after Tax)= 50* (0.70) = $35---------------------------------a)

Now For Bellingham- During Recession

EBIT= $50 million

Equity= $100 million

Debt= $100 million @ 10% (Let it be for a year)

So total interest to be paid= 100*(1.1)= $110-100= $10 million

Tax Rate= 30%

Now (Earning after interest)= 50 - 10 = $40

(Earning after Tax)= 40*(0.70) =$28--------------------------------b

Now let number of shares are equal = 10000000 shares

so dividend for Adams inc.= $35 million/ no. of shares = $3.5/ share

and for Bellingham dividend= $28million/no. of share= 2.8/share

For Adams inc. as it is funded by entirely equity so $35 million will be distributed to Investors and in case of Bellingham it will first pay to debt holders ($10million as interest expense) and then pay the remaning amount to equity investors.

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