36. Assume that ADI Company, with long-term capitalization consisting entirely o

Question

36. Assume that ADI Company, with long-term capitalization consisting entirely of S5 million in stock, wants to raise $2 million for the acquisition of special equipment by: (a) selling 40,000 shares of common stock at $50 each; (b) selling bonds at 10% interest, or (c) issuing preferred stock with an 8% dividend. The present EBIT is $1 million, the tax rate is 50%, and 100,000 anding. The projected operating profit is $1 million. Calculate the EPS for the three financing alternatives. Find both shares of common stock are now outst indifference points.

Explanation / Answer

1) EPS is computed as -

EPS = Earnings available to Equity stockholders / No. of Shares

Earnings available to Equity stockholders are the earnings remaining after all interest, Taxes and preferred dividend payments.

2) The indifference point is the level of EBIT at which EPS under two option is same -

Option A & B

EPS under Option A = EPS under Option B

Or, [EBIT x (1 - Tax rate)] / No. of shares = [(EBIT - Interest) x (1 - Tax rate)] / No. of shares

Or, [EBIT x (1 - 0.50)] / 140,000 = [(EBIT - 200,000) x (1 - 0.50)] / 100,000

Or, 0.50 EBIT x 100,000 = (0.50 EBIT - 100,000) x 140,000

Or, EBIT = $700,000

Option A and C

EPS under Option A = EPS under Option B

Or, [EBIT x (1 - Tax rate)] / No. of shares = [(EBIT) x (1 - Tax rate) - Preference Dividend] / No. of shares

Or, [EBIT x (1 - 0.50)] / 140,000 = [(EBIT) x (1 - 0.50) - $160,000] / 100,000

Or, 0.50EBIT x 100,000 = (0.50 EBIT - $160,000) x 140,000

Or, EBIT = $1,120,000

Particulars Option A - Equity Option B - Debt Option C - Preffered Stock EBIT $1,000,000 $1,000,000 $1,000,000 Less: Interest 0 $2,000,000 x 10% = $200,000 0 EBT $1,000,000 $800,000 $1,000,000 Less: Tax@50% $500,000 $400,000 $500,000 Net Profit $500,000 $400,000 $500,000 Less: Preferred Dividend 0 0 $2,000,000 x 8% = $160,000 Earnings available to Equity shareholders' $500,000 $400,000 $340,000 No. of equity shares 100,000 + 40,000 = 140,000 100,000 100,000 EPS $3.57 $4.00 $3.40

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