Edsel Research Labs has $27 million in assets. Currently, half of these assets a

Question

Edsel Research Labs has $27 million in assets. Currently, half of these assets are financed with long-term debt at 5 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 5 percent. The tax rate is 30 percent. Under Plan D, a $6.75 million long-term bond would be sold at an interest rate of 11 percent and 675,000 shares of stock would be purchased in the market at $10 per share and retired. Under Plan E, 675,000 shares of stock would be sold at $10 per share and the $6,750,000 in proceeds would be used to reduce long-term debt How would each of these plans affect earnings per share? Consider the current plan and the two new plans.

Explanation / Answer

The calculation of Earnings Per Share has been shown in the table below:

Plan D would reduce the EPS from the current level.

Plan E would result in same EPS as at the current level.

___________

Notes:

1)

Interest (Current Plan) = 27,000,000*50%*5% = $675,000

Interest (Plan D) = 27,000,000*50%*5% + 6,750,000*11% = $1,417,500

Interest (Plan E) = (27,000,000*50% - 6,750,000)*5% = $337,500

_______

2)

Common Shares (Current Plan) = (27,000,000*50%)/10 = 1,350,000 shares

Common Shares (Plan D) = 1,350,000 (Current Shares) - 675,000 (Shares Purchased and Retired) = 675,000 shares

Common Shares (Plan E) = 1,350,000 (Current Shares) + 675,000 (New Shares) = 2,025,000 shares

Current Plan Plan D Plan E EBIT (27,000,000*5%) 1,350,000 1,350,000 1,350,000 Less Interest 675,000 1,417,500 337,500 EBT 675,000 -67,500 1,012,500 Less Taxes 202,500 -20,250 303,750 EAT (A) 472,500 -47,250 708,750 Common Shares (B) 1,350,000 675,000 2,025,000 EPS (A/B) $0.35 -$0.07 (Decrease) $0.35 (Constant)

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