R.L. Smith currently has 100,000 shares of common stock, 10,000 shares of prefer
ID: 2764727 • Letter: R
Question
R.L. Smith currently has 100,000 shares of common stock, 10,000 shares of preferred stock that pays a $2.00 dividend, and $4,000,000 of 10% debt They need to raise an additional 2.5 million dollars. They can do this by issuing another 40,000 shares of stock or 2.5 million dollars of debt which will have a cost of 12%. What is the DFL at an expected EBIT of $700,000 for each of the options above and at his point how much would EPS change if EBIT were to increase by 10%. What is the financial breakeven point for each plan. At what level of EBIT does the plan where debt is used dominate the option of issuing new equity. If EBIT is $900,000 which plan should the company use.Explanation / Answer
At Expected EBIT of $700000 If R.L. Smith Chooses first option to Issue the Equity Share then
EBT= EBIT-Interest
=$700,000-$400,000
=$3,00,000
DFL= EBIT/EBT
=$700000/$300000
=2.33
If Option 2 is opted then EBT=700000- 400000-300000
=0
DFL =$700000/0
company will be fully levered.
IF EBIT increases by 10% EBIT will be $770000
EBT will be $370000
Less: Pref Dividend $20000
Profit available for Equity Shareholders=$350000
No of Equity Shareholders= (100000+40000)=140000
EPS= 2.5
Under Old EBIT EPS would have been= $280000/140000
EPS= 2
So EPS change by $0.50 per share
Financial Brekeven Point for Plan-1
Interest of $400000
Plus Pref. Dividend $20000
Financial breakeven EBIT= $420000
Plan-2
Interest $700000
Plus Pref Dividend =$20000
Financial Brekeven EBIT=$720000
At EBIT 9,00,000
Option-1
EBT= $900000-$400000
EPS =500000-20000/140000
3.43
Option-2
EPS= 180000/100000
1.8
Option 1 is prefererd.
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