Edsel Research Labs has $24 million in assets. Currently half of these assets ar

Question

Edsel Research Labs has $24 million in assets. Currently half of these assets are financed with long-term debt at 8 percent and half with common stock having a par value of $10. Ms. Edsel, the vice-president of finance, wishes to analyze two refinancing plans, one with more debt (D) and one with more equity (E). The company earns a return on assets before interest and taxes of 8 percent. The tax rate is 40 percent.
Under Plan D, a $6 million long-term bond would be sold at an interest rate of 10 percent and 600,000 shares of stock would be purchased in the market at $10 per share and retired. Under Plan E, 600,000 shares of stock would be sold at $10 per share and the $6,000,000 in proceeds would be used to reduce long-term debt.

(a-1) How would each of these plans affect earnings per share? (Round your answers to 2 decimal places. Omit the "$" sign in your response.)

Earnings
per share
Current Plan $
Plan D $
Plan E $

Explanation / Answer

Current Assets 24,000,000 Debt 12,000,000 @ 8% Stock 12,000,000 1,200,000 at $10 /share EBIT 1,920,000 24,000,000 *8% Interest 960,000 12,000,000*.08 Taxes 264,000 (1,920-960)*.4 Net Income 576,000 EPS 0.48 (576,000/1,200,000) Plan D Debt 12,000,000 @ 8% 6,000,000 @10% Stock 6,000,000 600,000 @ 10 EBIT 1,920,000 Interest 1,560,000 12,000,000*.08 +6,000,000*10 Taxes 144,000 (1,920-1,560) *.40 Net Income 216,000 EPS 0.36 (216,000/600,000) Plan E EBIT 1,920,000 Interest 480,000 (6,000,000* .08) Taxes 576,000 (1,920-480).40 Net Income 864,000 EPS 0.48 (864,000/1,800,000) Bottom line here is when you aren't making any more on your assets than you have to pay on your debt, leverage doesn't do you much good.

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