DAR Corporation is comparing two different capital structures: an all-equity pla
ID: 2763734 • Letter: D
Question
DAR Corporation is comparing two different capital structures: an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, the company would have 170,000 shares of stock outstanding. Under Plan II, there would be 120,000 shares of stock outstanding and $2.4 million in debt outstanding. The interest rate on the debt is 7 percent, and there are no taxes.
If EBIT is $450,000, what is the EPS for each plan? (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)
If EBIT is $700,000, what is the EPS for each plan? (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)
What is the break-even EBIT? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, e.g., 1,234,567.)
DAR Corporation is comparing two different capital structures: an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, the company would have 170,000 shares of stock outstanding. Under Plan II, there would be 120,000 shares of stock outstanding and $2.4 million in debt outstanding. The interest rate on the debt is 7 percent, and there are no taxes.
Explanation / Answer
EPS = (EBIT - Debt Interest) X (1 - Tax Rate) / Number of Equity Shares Outstanding
& Debt Interest = Debt Outstanding X Rate of Interest
So here,
Plan I
EPS = ($450,000 – (0X7%) / $170,000
EPS = $2.65
Plan II
EPS = ($450,000 – ($2,400,000 X 7%) / $120,000
EPS = $282,000 / $120,000
EPS = $2.35
Plan I
EPS = ($700,000 – (0X7%) / $170,000
EPS = $4.12
Plan II
EPS = ($700,000 – ($2,400,000 X 7%) / 120,000
EPS = $532,000 / $120,000
EPS = $4.43
When assessing the relative effectiveness leverage versus equity financing, companies look for the level of EBIT where EPS remains unaffected, called the EBIT-EPS break-even point. This calculation determines how much additional revenue would need to be generated in order to maintain a constant EPS under different financing plans.
Break Even EBIT is that level of EBIT, where the EPS of the two capital structure is same.
So here,
EBIT / 170,000 = EBIT – ($2,400,000X7%) / 120,000
EBIT / 170,000 = EBIT – 168,000 / 120,000
EBIT = 1.41666667(EBIT – 168,000)
EBIT = 238,000 / 0.41666667
EBIT = $571,200 <- Break Even EBIT
We can check the same by putting the EBIT in the earlier equations:
Plan I - ($571,200/170000) = $3.36
Plan II – ($571,200-$168,000) / 120,000 = 3.36
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