Wonder Diaper is considering two possible capital structures, A and B Souroe of

Question

Wonder Diaper is considering two possible capital structures, A and B Souroe of Copital Snucture A Structure B Longe term debt Preferred stock Common stock S75,000-t 16% $10,000 at 18% 8,000 shares at $20 $50,000 at 15% $15,000 at 189 10,000 shares at $20 Their expected EBIT is 30,000 a Calculate the financial breakeven point, and the earnings per share for each struchure Assume a 40% tax rate on ordinary income b) Graph the two capital structures on the same set ofEBIT-EPS axes c. Compute the degree of financial leverage with each structure d Carefully explain what Financial Leverage is

Explanation / Answer

EBIT is given to be $ 30,000

Tax rate is 40% on ordinary income

Now to get net income , first of all we need to know the interest payments made by the company onthe long term debt

Under structure A, $ 75000 at 16% is being paid out as interest , therefore, interest cost is $ 75000*16%= $ 12,000

Under structure B, $ 50,000 at 15% is being paid out as interest, therefore, interest cost is $ 50000*15%= $ 7,500

Therefore , earninings before tax under structure A= EBIT-Interest payment= $ 30,000- $ 12,000= $ 18,000 and net earnings after tax = $18,000* (1-40%)=$10,800

Similarly, earnings before tax under structure B= EBIT -Interest payment = $ 30,000-$ 7,500= $22,500 and net earnings after tax= $ 22500*(1-40%)= $13,500

To calculate Earnings per share, we need to use formula (net income - dividends on preferred stock)/ average outstanding share

Under structure A , dividend on preferred stock = $ 10000 at 18% = $ 1800

Under Structure B, dividend on preferred stock= $ 15000 at 18% = $ 2700

Earnings per share under structure A = ($ 10,800-$1,800)/8000= 1.125

Earnings per share under structure B= ($ 13,500- $ 2,700)/10000= 1.08

Financial break even point is the minimum level of EBIT required to pay off the commitments of interest, preference dividend and tax

So basically, net profit after tax= preference dividend at financial Breakeven point------(1)

Under structure A, interest cost is $ 12,000, preference dividend= $ 1800------------(2)

Under structure B, interest cost is $ 7,500, preference dividend= $ 2700--------------(3)

from (1) & (2) , we get (EBIT- $12000)* (1-40%)= $ 1800

(EBIT-12000)*0.6= $ 1800

0.6EBIT- $7,200= $ 1,800

0.6EBIT= $9,000

EBIT= $15,000....this is the financial break even point under structure A

From (1) & (3) ,we get (EBIT-$7500)*(1-40%)= $2,700

0.6EBIT- $4500= $ 2700

EBIT= $ 12,000....this is the financial break even point under structure B

To answer question 2 , for plotting EBIT and EPS under these two structures for same level of EBIT, we need to bring in more data points. We know that at EBIT of $ 30,000, EPS under structure A = 1.125 and EPS under structure B = 1.08

now if we increase EBIT by $ 10000, numerator of EPS equation will increase by $ 6000 as $ 4000 will go in taxes

and if we decrease EBIT by $ 10000, numerator of EPS equation will decrease by $ 6000 as $ 4000 will be saved in taxes

Therefore, revised EPS under structure A when EBIT is $ 40,000 is ($ 9000+$ 6000)/8000= 1.875

revised EPS under structure A when EBIT is $ 20000 is ($ 9000-$ 6000)/8000=0.375

Similarly, revised EPS under structure B when EBIT is $40000 is ($10800+$6000)/10000= $16,800/10000=1.68

and EPS under structure B when EBIT is $20000 is ($10800-$6000)/10000= 0.48

Using these values, you can plot the graph for both structure A and B at given level of EPS

Degree of financial leverage under structure A= EBIT/ (EBIT-Interest)= $30000/($30000-$12000)= 30000/18000=1.67

Degree of financial leverage under structure B = EBIT/ (EBIT- Interest)= $ 30000/ ($30000- $7500)= 30000/22,500=1.33

Degree of financial leverage is a measure used to estimate changes in operating income due to changes in capital structure. It is essentially used to find out if taking more debt actually paid off the company in terms of more operating income i.e. more EBIT or it did not help

Source of Capital Structure A Structure B Long term Debt $75000 at 16% $ 50000 at 15% Preferred Stock $10000 at 18% $ 15000 at 18% Common Stock 8000 shares at $ 20 10000 shares at $ 20

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