Frankline Coin Company is considering two capital structures. The key informatio

Question

Frankline Coin Company is considering two capital structures. The key information follows. Assume a 40% tax rate. Calculate the financial breakeven point for each plan and the indifference point for the two plans. Calculate the DFL for each plan at the expected EBIT of $50,000. Use this number to explain what change would be expected from a 20% increase (decrease) in EBIT. Indicate over what EBIT range, if any, each structure is preferred. If EBIT is $35,000, what are EPS under each plan? What if EBIT is $60,000?

Explanation / Answer

1. Breakeven point shall be that level of EBIT where EPS in both plans is equal.

(EBIT - 500000*8% - 20000*$1) / 10000 = (EBIT - 350000*7% - 10000*1) / 20000

(EBIT - 40000 - 20000) = (EBIT - 24500 - 10000 ) / 2

EBIT = $85500

Breakeven point = $85500

2. DFL = EBIT / EBIT - Interest

Plan A: 50000 / (50000 - 40000) = 5

Plan B : 50000 / (50000 - 24500) = 1.96

DFL is also equal to % change in EPS/ % change in EBIT

This means, in case of:

Plan A: For 1% change in EBIT EPS would change by 5%. If EBIT changes by 20% (+/-) EPS would be change by 100%.

Plan B: For 1% change in EBIT EPS would change by 1.96%. If EBIT changes by 20% (+/-) EPS would be change by 39.20%.

3. EBIT should be more that the level at which it is able to cater to interest and preferred dividend.

In case of Plan A: Over (40000+20000) = Over $60000

In case of plan B : Over (24500 + 10000) = Over $34500

4. When EBIT = $35000:

Plan A EPS = (35000 - 500000*8% - 20000*$1) / 10000 = -$2.50

Plan B EPS = (35000 - 350000*7% - 10000*1) / 20000 = $0.025

When EBIT = $60000:

Plan A EPS = (60000 - 500000*8% - 20000*$1) / 10000 = 0

Plan B EPS = (60000 - 350000*7% - 10000*1) / 20000 = $1.275

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