DEF Company is comparing three different capital structures. Plan I would result
ID: 2801717 • Letter: D
Question
DEF Company is comparing three different capital structures. Plan I would result in 800 shares of stock and $9,000 in debt. Plan II would result in 700 shares of stock and $13,500 in debt. Plan III is an all-equity plan and would result in 1,000 shares of stock. The firm’s EBIT will be $8,000 per year until infinity. The interest rate on the debt is 10%.
. Ignoring taxes, compute the EPS for each of the three plans. Which of the three plans has the highest EPS? Which has the lowest? (4 marks)
b. Compute the break-even EBIT that will cause the EPS on Plan I to be equal to the all-equity EPS. (2 marks)
c. Compute the break-even EBIT that will cause the EPS on Plan II to be equal to the all-equity EPS. (2 marks)
d. Compare your results from parts (b) and (c) above. Is one higher than the other? Why? (1 mark)
e. Ignoring taxes, what is the break-even EBIT that will cause the EPS on Plan I to be equal to the EPS on Plan II? What conclusions do you reach when you compare the outcomes of parts (b), (c), and (e) above? (3 marks)
Explanation / Answer
(a) Plan 1 Plan 2 Plan 3 No. of shares 800 700 1000 Debt 9000 13500 0 Interest rate 10% 10% 10% Interest (Debt x Rate) 900 1350 0 EBIT 8000 8000 8000 Less Interest 900 1350 0 Earnings Available to Shareholders 7100 6650 8000 No. of shares 800 700 1000 EPS 8.875 9.5 8 (b) Break even EBIT (Plan 1 and Plan 3) Let, Break even EBIT = E (E - 900)/800 = E/1000 1000E - 900000 = 800 E E = 900000/(1000-800) E = 4500 (c ) Break even EBIT (Plan 2 and Plan 3) Let, Break even EBIT = E (E - 1350)/700 = E/1000 1000E - 1350000 = 700E E = 1350000/(1000-700) E = 4500 (d) Both the results are equal. Means at EBIT 4500 all three plans will provide same EPS. (e) Break even EBIT (Plan 1 and Plan 2) Let, Break even EBIT = E (E - 900)/800 = (E - 1350)/700 700E - 630000 = 800E -1080000 E = (1080000-630000)/(800-700) E = 450000/100 E = 4500 Conclusion - EBIT - Below 4500 Plan 3 is better At 4500 Plan 1, 2, 3 Are indifferent Above 4500 Plan 1 or 2 Please provide feedback…. Thanks in advance…. :-)
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