1.Lambdoid Corporation is comparing two different capital structures, an all-equ
ID: 2793547 • Letter: 1
Question
1.Lambdoid Corporation is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, Lambdoid would have 200,000 shares of stock outstanding. Under Plan II, there would be 100,000 shares of stock outstanding and $4 million in debt outstanding. The interest rate on the debt is 10% and there are no taxes.
a.If EBIT is $500,000, which plan will result in higher EPS?
b.If EBIT is $3.5 million, which plan will result in higher EPS?
c.What is the break-even EBIT?
Explanation / Answer
a
Plan 1
EBIT=500000
As no debt and taxes, Net Income=EBIT
EPS=Net Income/Number of shares=500000/200000=2.5
Plan 2
EBIT=500000
Interest=4000000*10%=400000
As no taxes, Net Income=EBT=500000-400000=100000
EPS=Net Income/Number of shares=100000/100000=1
Hence, plan 1 has higher EPS
b
Plan 1
EBIT=3500000
As no debt and taxes, Net Income=EBIT
EPS=Net Income/Number of shares=3500000/200000=17.5
Plan 2
EBIT=3500000
Interest=4000000*10%=400000
As no taxes, Net Income=EBT=3500000-400000=3100000
EPS=Net Income/Number of shares=3100000/100000=21
Hence, plan 2 has higher EPS
c
Breakeven EBIT is the level at which EPS in both the cases are same
Let EBIT be x
Then EPS in plan1=x/200000
EPS in plan2=(x-400000)/100000
Hence,
x/200000=(x-400000)/100000
=>x=800000
Break even EBIT=800000
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