Lenow’s Drug Stores and Hall’s Pharmaceuticals are competitors in the discount d
ID: 2737237 • Letter: L
Question
Lenow’s Drug Stores and Hall’s Pharmaceuticals are competitors in the discount drug chain store business. The separate capital structures for Lenow and Hall are presented next.
Complete the following table given earnings before interest and taxes of $13,000, $24,000, and $53,000. Assume the tax rate is 30 percent. (Leave no cells blank - be certain to enter "0" wherever required. Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places.)
What is the relationship between the EPS
of the two firms?
State the relationship between earnings per share and the level of EBIT.
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?
Lenow Hall Debt @ 10% $ 80,000 Debt @ 10% $ 160,000 Common stock, $10 par 160,000 Common stock, $10 par 80,000 Total $ 240,000 Total $ 240,000 Common shares 16,000 Common shares 8,000
Explanation / Answer
Solution:
a.
EBIT
Total Assets
EBIT/TA
Lenow EPS
Hall EPS
What is the relationship between the EPS
of the two firms?
13,000
240,000
5.42%
0.22
-0.26
Lenow’s EPS > Hall’s EPS
24,000
240,000
10%
0.7
0.7
Lenow EPS = Hall EPS
53,000
240,000
22.08%
1.97
3.24
Lenow EPS < Hall EPS
Calculations:
Lenow EPS = (EBIT – Interest – Taxes)/Number of shares
EPS = [13,000 – (10%*80,000)]*(1 – 0.3)/16,000 = 0.22
EPS = [24,000 – (10%*80,000)]*(1 – 0.3)/16,000 = 0.70
EPS = [53,000 – (10%*80,000)]*(1 – 0.3)/16,000 = 1.97
Hall EPS = (EBIT – Interest – Taxes)/Number of shares
EPS = [13,000 – (10%*160,000)]*(1 – 0.3)/8,000 = -0.26
EPS = [24,000 – (10%*160,000)]*(1 – 0.3)/8,000 = 0.70
EPS = [53,000 – (10%*160,000)]*(1 – 0.3)/8,000 = 3.24
b- 1.
EBIT/TA rate = 10%
b-2.
Cost of debt = 10%
b-3:
EPS is unaffected by financial leverage when the pre-tax return on assets (EBIT/TA) equals the cost of debt.
c) At the EBIT break-even level:
EBIT/TA = Cost of debt
EBIT = Cost of debt x TA
EBIT = 0.22 x 240,000
EBIT = $52,800
EBIT
Total Assets
EBIT/TA
Lenow EPS
Hall EPS
What is the relationship between the EPS
of the two firms?
13,000
240,000
5.42%
0.22
-0.26
Lenow’s EPS > Hall’s EPS
24,000
240,000
10%
0.7
0.7
Lenow EPS = Hall EPS
53,000
240,000
22.08%
1.97
3.24
Lenow EPS < Hall EPS
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