Academic Integrity: tutoring, explanations, and feedback — we don’t complete graded work or submit on a student’s behalf.

1.Lambdoid Corporation is comparing two different capital structures, an all-equ

ID: 2793547 • Letter: 1

Question

1.Lambdoid Corporation is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, Lambdoid would have 200,000 shares of stock outstanding. Under Plan II, there would be 100,000 shares of stock outstanding and $4 million in debt outstanding. The interest rate on the debt is 10% and there are no taxes.

a.If EBIT is $500,000, which plan will result in higher EPS?

b.If EBIT is $3.5 million, which plan will result in higher EPS?

c.What is the break-even EBIT?

Explanation / Answer

a
Plan 1
EBIT=500000
As no debt and taxes, Net Income=EBIT
EPS=Net Income/Number of shares=500000/200000=2.5

Plan 2
EBIT=500000
Interest=4000000*10%=400000
As no taxes, Net Income=EBT=500000-400000=100000
EPS=Net Income/Number of shares=100000/100000=1

Hence, plan 1 has higher EPS

b

Plan 1
EBIT=3500000
As no debt and taxes, Net Income=EBIT
EPS=Net Income/Number of shares=3500000/200000=17.5

Plan 2
EBIT=3500000
Interest=4000000*10%=400000
As no taxes, Net Income=EBT=3500000-400000=3100000
EPS=Net Income/Number of shares=3100000/100000=21

Hence, plan 2 has higher EPS

c
Breakeven EBIT is the level at which EPS in both the cases are same
Let EBIT be x
Then EPS in plan1=x/200000
EPS in plan2=(x-400000)/100000
Hence,
x/200000=(x-400000)/100000
=>x=800000
Break even EBIT=800000