Dream Corp is comparing two different capital structures: an all equity plan (Pl
ID: 2755972 • Letter: D
Question
Dream Corp is comparing two different capital structures: an all equity plan (Plan A) and a lev ered plan (Plan B). Under Plan A the company would have 160,000 shares of stock outstanding. Under Plan B, there would be 80,000 shares of stock outstanding and $2.8 million in debt outstanding. The interest on debt is 8% If EBIT is $350,000 which plan will result in the higher EPS? b. If EBIT is $600,000 which plan will result in the higher EPS? c. What is the break even EBIT for the two plans? Please interpret what the break even EBIT you find means. d. What is meant by business risk and financial risk? e. Explain this statement: “The optimal capital structure for a firm is 50% debt and 50% equity.
Explanation / Answer
Assumption : Tax rate is zero
a.When EBIT is $350,000
Plan A
Plan B
EBIT
$350,000
$350,000
Interest
0
=8%*$2,800,000
$224,000
EBT
$350,000
$126,000
Number of Shares
160,000
80,000
EPS = EBT / Number of Shares
$ 2.19
$ 1.58
The answer for question a is Plan A
b.When EBIT is $600,000
Plan A
Plan B
EBIT
$600,000
$600,000
Interest
0
=8%*$2,800,000
$224,000
EBT
$350,000
$376,000
Number of Shares
160,000
80,000
EPS = EBT / Number of Shares
$ 2.19
$ 4.70
The answer for question b is Plan B
c.Calculating Breakeven EBIT
EBIT/160,000 = (EBIT - 224,000)/80,000
Step 1:
EBIT = [(EBIT - 224000) * 160,000]/ 80,000
Step 2:
EBIT = (EBIT - 224000) * 2
Step 3:
EBIT = 2EBIT - 448000
Step 4:
EBIT = 448,000
Break even EBIT is the EBIT where irrespective of the capital structure investors will receive same EPS
Plan A
Plan B
EBIT
$350,000
$350,000
Interest
0
=8%*$2,800,000
$224,000
EBT
$350,000
$126,000
Number of Shares
160,000
80,000
EPS = EBT / Number of Shares
$ 2.19
$ 1.58
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.