Lecture 9: Capital Structurel 1. EBIT and Leverage Music City, Inc,, has no debt
ID: 2795896 • Letter: L
Question
Lecture 9: Capital Structurel 1. EBIT and Leverage Music City, Inc,, has no debt outstanding and a total market value of $295,000. Earnings before interest and taxes, EBIT, are projected to be $23,000. The company is considering an used to repurchase shares of stock. There are currently 5,000 shares outstanding. Assum e that the company has a tax rate of 35 percent. a. Show the company's balance sheet of current (i.e., all equity financed) and proposed capital structure. b. Calculate EPS under the current all-equity capital structure and under the proposed financing plan. c. At what EBIT will EPS be the same between the two capital structures? In other words, what is the break even EBIT? Draw a graph that shows EPS and EBIT relations as we did in class. d.Explanation / Answer
a.
Current ($)
Proposed ($)
Equity
295,000
206,500
Debt
0
88,500
Total
295,000
295,000
b.
Current ($)
Proposed ($)
EBIT
23,000
23,000
EBT (EBIT – Interest)
23,000
15,920 (23,000 – 7,080)
Net Income (EBT – Tax)
14,950 (23,000*(1-0.35))
10,348 (15,920*(1-0.35))
EPS (Net Income / No. of shares)
2.99 (14,950/5,000)
2.96 (10,348/3,500)
Interest = 88,500*8%
= 7,080
Shares re-purchased = 295,000/5,000
= $ 59/ share
= 88,500 (proceeds from debt issue / 59)
=1,500 shares
c. EBIT's should be the same under both structures and lets consider as x
{EBIT*(1 – tax rate)} / No. of shares = {(EBIT-I)*(1 – tax rate)} / No. of shares
0.65x / 5000 = {(x-7,080)*(1-0.35)} / 3500
0.65x/5000 = (0.65x - 4602) / 3500
x = $ 23,600
EPS will be the same if EBIT is $ 23,600
Current ($)
Proposed ($)
Equity
295,000
206,500
Debt
0
88,500
Total
295,000
295,000
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