Bebe Metals is planning a major expansion program requiring $10,000,000 in finan

Question

Bebe Metals is planning a major expansion program requiring $10,000,000 in financing. Bebe’s may sell bonds with a 6% coupon rate or sell 200,000 shares of common stock to get the needed funds. After the expansion there is a 50% probability of EBIT (Earnings Before Interest and Taxes) being $5 million, a 20% probability of it being $3 million and a 30% probability of it being $4 million. The following data was taken from the firm’s pre-expansion income statement:

Interest expense                                 $200,000

Tax Rate                                              40%

Common shares outstanding             350,000

Calculate the EPS based on the expected EBIT under each alternative.

Which plan would you chose at this level of EBIT?

Compute the DFL (Degree of Financial Leverage) at the expected level of EBIT under each financing alternative. If EBIT increased by 10%, what would the new EPS be under each alternative?

Explanation / Answer

1. EPS based on expected EBIT under each alternative method. Expected EBIT after expansion - (Amount in $) Profit Probablity Expected profit (A) (B) (A*B)                         50,00,000 0.5                 25,00,000                         30,00,000 0.2                   6,00,000                         40,00,000 0.3                 12,00,000 EBIT                 43,00,000 Calculation of EPS under both alternatives (Amount in $) Alternative 1 Alternative 2 Expected EBIT           43,00,000                 43,00,000 less : Intetest expense              2,00,000                   2,00,000 Less: Interest on Bonds (10,000,000 * .08)              8,00,000                                -             33,00,000                 41,00,000 Less : Tax @ 40%           13,20,000                 16,40,000 Profit After tax (A)           19,80,000                 24,60,000 Existing no. of shares              3,50,000                   3,50,000 New shares                           -                     2,00,000 Total number of shares (B)              3,50,000                   5,50,000 EPS (A/B)                      5.66                            4.47 2. Based on EPS, Alternative one of issuing of Bonds is Prefereable. 3. Degree of Financial leverage = EBIT/(EBIT - Interest) (Amount in $) Alternative 1 Alternative 2 EBIT (A)           43,00,000                 43,00,000 Interest (B)           10,00,000                   2,00,000 EBIT - Interest {C = A-B}           33,00,000                 41,00,000 Degree of Financial leverage (A/C)                      1.30                            1.05 4. Revised expected EPS, If EBIT increased by 10% (Amount in $) Revised EBIT (43,00,000*1.1)                 47,30,000 Alternative 1 Alternative 2 Expected EBIT           47,30,000                 47,30,000 less : Intetest expense              2,00,000                   2,00,000 Less: Interest on Bonds (10,000,000 * .08)              8,00,000                                -             37,30,000                 45,30,000 Less : Tax @ 40%           14,92,000                 18,12,000 Profit After tax (A)           22,38,000                 27,18,000 Existing no. of shares              3,50,000                   3,50,000 New shares                           -                     2,00,000 Total number of shares (B)              3,50,000                   5,50,000 EPS (A/B)                      6.39                            4.94

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