Leno\'s Drug Stores and Hall\'s Pharmaceuticals are competitors in the discount

Question

Leno's Drug Stores and Hall's Pharmaceuticals are competitors in the discount drug chain store business. The separate capital structures for Leno and Hall are presented below.

                                                        Leno                                                       Hall

Debt @ 10%                                   $100,000                                                 Debt @ 10%                                             $200,000

Common stock, $10 par                 $200,000                                                  Common stock, $10 par                             100,000

Total                                               $300,000                                                   Total                                                          $300,000

Shares                                            20,000                                                       Common shares                                       10,000

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(a) Compute earnings per share if earnings before interest and taxes are $20,000, $30,000, and $120,000 (assume a 30 percent tax rate).

(b) Explain the relationship between earnings per share and the level of EBIT.

(c) If the cost of debt went up to 12 percent and all other factors remained equal, what would be the break-even level for EBIT?

Explanation / Answer

Details Leno Hall Debt @10%                100,000             200,000 Common Stock $10 par(par value)                200,000             100,000 No of Common Stock                  20,000               10,000 a        1 EBIT                    20,000               20,000 Less Interest                    10,000               20,000 Taxable Income                    10,000                         -   Tax @30%                    3,000                         -   Net Income                      7,000                         -   EPS=Net Income/No of shares= $                  0.35 $                    -          2 EBIT                    30,000               30,000 Less Interest                    10,000               20,000 Taxable Income                    20,000               10,000 Tax @30%                    6,000                  3,000 Net Income                    14,000                  7,000 EPS=Net Income/No of shares= $                  0.70 $                0.70        3 EBIT                  120,000             120,000 Less Interest                10,000.0            20,000.0 Taxable Income                  110,000             100,000 Tax @30%                  33,000               30,000 Net Income                    77,000               70,000 EPS=Net Income/No of shares= $                  3.85 $                7.00 b The EPS is higher in a company with higher debt when the EBIT   increases over the fixed interest charges than in a company with low exposure to debt. This is called financial leverage. c Assume Cost of Debt =12% And at EBIT k , the EPS of both the   companies are same. Details EBIT   k k Less Interest                  12,000               24,000 Taxable Income   k-12000 k-24000 Tax @30% 0.30(k-12000) 0.30(k-24000) Net Income   0.70(k-12000) 0.70(k-24000) EPS=Net Income/No of shares= 0.70(k-12000)/20000 0.70(k-24000)/10000 So At break even : 0.70(k-12000)/20000=0.70(k-24000)/10000 k-12000=2k-48000 k=36000 So required Break even EBIT =$36000

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