Destin Corp. is comparing two different capital structures. Plan I would result
ID: 2718692 • Letter: D
Question
Destin Corp. is comparing two different capital structures. Plan I would result in 14,000 shares of stock and $100,000 in debt. Plan II would result in 10,800 shares of stock and $180,000 in debt. The interest rate on the debt is 8 percent.
Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $90,000. The all-equity plan would result in 18,000 shares of stock outstanding. What is the EPS for each of these plans? (Round your answers to 2 decimal places. (e.g., 32.16))
In part (a), what are the break-even levels of EBIT for each plan as compared to that for an all-equity plan?
Ignoring taxes, at what level of EBIT will EPS be identical for Plans I and II?
Assuming that the corporate tax rate is 40 percent, what is the EPS of the firm? (Round your answers to 2 decimal places. (e.g., 32.16))
Assuming that the corporate tax rate is 40 percent, what are the break-even levels of EBIT for each plan as compared to that for an all-equity plan?
Assuming that the corporate tax rate is 40 percent, when will EPS be identical for Plans I and II?
Destin Corp. is comparing two different capital structures. Plan I would result in 14,000 shares of stock and $100,000 in debt. Plan II would result in 10,800 shares of stock and $180,000 in debt. The interest rate on the debt is 8 percent.
Explanation / Answer
Answer (a)
EPS
Plan I
$ 5.86
Plan II
$ 7.00
All Equity
$ 5.00
Answer (b)
EBIT
Plan I and all-equity
$ 78,000
Plan II and all-equity
$ 68,400
Answer (c)
EBIT = $ 36,000
Answer (d-1)
EPS
Plan I
$ 3.51
Plan II
$ 4.20
All Equity
$ 3.00
Answer (d-2)
EBIT
Plan I and all-equity
$ 78,000
Plan II and all-equity
$ 68,400
Answer (d-3)
EBIT = $ 36,000
working
Plan I
Number of Shares outstanding = 14000
Amount of Debt = $ 100,000
Interest rate on Debt = 8%
Plan II
Number of Shares outstanding = 10800
Amount of Debt = $ 180,000
Interest rate on Debt = 8%
All Equity firm
Number of Shares outstanding = 18000
EBIT = $ 90,000
Calculation of EPS under various Plans
All Equity Plan
Plan I
Plan II
EBIT
$ 90,000
$ 90,000
$ 90,000
Interest
0
$ 8,000
$ 14,400
EBT
$ 90,000
$ 82,000
$ 75,600
Taxes
0
0
0
Net Income
$ 90,000
$ 82,000
$ 75,600
No of shares outstanding
18000
14000
10800
Earning Per Share
$ 5.00
$ 5.8571
$ 7.00
Interest expense under Plan I = $ 100,000 * 8% = $ 8,000
Interest expense under Plan II = $ 180,000 * 8% = $ 14,400
Break-even EBIT of Plan I and All Equity
At break-even EBIT, EPS of Plan I should be equal to that of All Equity firm.
Let X be the net income of Plan I to satisfy the above condition
That is
$ 5 = X / 14000
X = 14000 * $ 5 = $ 70,000
Break-even EBIT = Break-even net income + interest on debt = $ 70,000 + $ 8,000 = $ 78,000
Break-even EBIT of Plan II and All Equity
At break-even EBIT, EPS of Plan II should be equal to that of All Equity firm.
Let X be the net income of Plan II to satisfy the above condition
That is
$ 5 = X / 10800
X = 10800 * $ 5 = $ 54,000
Break-even EBIT = Break-even net income + interest on debt = $ 54,000 + $ 14,400 = $ 68,400
Let X be the EPS which is same for Plan I and Plan II. Then EBIT values Plan I and Plan II should be equal
14000 * X + 8000 = 10800 * X + 14400
14000 * X – 10800 * X = 14400 – 8000
3200 * X = 6400
X = 6400 / 3200 = $ 2
EBIT = 14000 * 2 + 8000 = 28,000 + 8,000 = $ 36,000
Corporate Tax rate = 40%
Calculation of EPS under various Plans
All Equity Plan
Plan I
Plan II
EBIT
$ 90,000
$ 90,000
$ 90,000
Interest
0
$ 8,000
$ 14,400
EBT
$ 90,000
$ 82,000
$ 75,600
Taxes
$ 36,000
$ 32,800
$ 30,240
Net Income
$ 54,000
$ 49,200
$ 45,360
No of shares outstanding
18000
14000
10800
Earning Per Share
$ 3.00
$ 3.51428
$ 4.20
Break-even EBIT of Plan I and All Equity
At break-even EBIT, EPS of Plan I should be equal to that of All Equity firm.
Let X be the net income of Plan I to satisfy the above condition
That is
$ 3 = X / 14000
X = 14000 * $ 3 = $ 42,000
Break-even EBT = Break-even net income /(1-tax rate) =$ 42,000 / (1-0.40) = $ 70,000
Break-even EBIT = Break-even EBT + Interest = $ 70,000 + $ 8000 = $ 78,000
Break-even EBIT of Plan II and All Equity
At break-even EBIT, EPS of Plan II should be equal to that of All Equity firm.
Let X be the net income of Plan II to satisfy the above condition
That is
$ 3 = X / 10800
X = 10800 * $ 3 = $ 32,400
Break-even EBT = Break-even net income /(1-tax rate) = $ 32,400/(1-0.40) = $ 54,000
Break-even EBIT = Break-even EBT + interest on debt = $ 54,000 + $ 14,400 = $ 68,400
Let X be the EPS which is same for Plan I and Plan II. Then EBIT values Plan I and Plan II should be equal
[(14000 * X)/(1-0.40)] + $ 8000 = [(10800 * X)/(1-0.40)] + $ 14400
[(14000*x)/0.6] + $ 8000 = [(10800 * X)/0.6] + $ 14400
[(14000*x)/0.6] - [(10800 * X)/0.6] = $ 14400 - $ 8000
X * [(14000/0.6) – (10800/0.6)] = $ 6,400
X * [3200/0.6] = $ 6,400
X = ($ 6,400 * 0.6) / 3200
X = $ 1.20
EBIT of Plan I = (14000 * 1.2) / (1-0.40) + $ 8000 = $ 16800/0.6 + $ 8000 = $ 36,000
EBIT of Plan II = (10800 * 1.2)/(1-0.40) + $ 14400 = $ 12960/0.6 + $ 14400 = $ 36,000
EPS
Plan I
$ 5.86
Plan II
$ 7.00
All Equity
$ 5.00
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