Break-even EBIT. Company X is comparing two different capital structures: an all

Question

Break-even EBIT. Company X is comparing two different capital structures: an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan l, the company would have 160,000 shares of stock outstanding. Under Plan ||, the company would have 80,000 shares of stock outstanding and $2.8 million of debt outstanding. The interest rate on the debt is 8 percent and assume NO taxes. A. If EBIT is $350,000, which plan will result in the higher EPS? B. If EBIT is $500,000, which plan will result in the higher EPS C. What is the Break-even EBIT such that the company is indifferent in EPS between Plan I and Plan ||.

Explanation / Answer

A.

Under Plan I, the unlevered company, net income is the same as EBIT with no corporate tax. The EPS under this capitalization will be:

EPS=350000/160000=2.1875

Under Plan II, the levered company, EBIT will be reduced by the interest payment. The interest payment is the amount of debt times the interest rate, so:

Net income=350000-0.08*2800000=126000

EPS=126000/80000=1.575

Plan I has the higher EPS when EBIT is 350000

B.

Under Plan I, the unlevered company, net income is the same as EBIT with no corporate tax. The EPS under this capitalization will be:

EPS=500000/160000=3.1250

Under Plan II, the levered company, EBIT will be reduced by the interest payment. The interest payment is the amount of debt times the interest rate, so:

Net income=500000-0.08*2800000=276000

EPS=276000/80000=3.45

Plan II has the higher EPS when EBIT is  500000

C. To find the breakeven EBIT for two different capital structures, we simply set the equations for EPS equal to each other and solve for EBIT. The breakeven EBIT is

EBIT/160000=(EBIT-0.08*2800000)/80000

EBIT=2EBIT-448000

EBIT=448000

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