Sally\'s Legal Services, Inc. has 200 common shares outstanding. The company nee

Question

Sally's Legal Services, Inc. has 200 common shares outstanding. The company needs an additional $10,000 to buy a new machine. It is considering two alterna- tives to raise the money: (1) issue 100 new shares of common stock at $100 par value, and (2) issue bonds (or debt) at a 6 percent interest rate. With either the common stock or the debt alternative, it is expected that the firm's EBIT will be $2,400 and its tax rate is 50 percent. 43 Determine the earnings per share for each financing option. Determine the EBIT indifference point between the two methods of financ- ing Determine the earnings per share at the EBIT indifference point. (a) (b) (c)

Explanation / Answer

a)

b)At indifference point , Earning per share under both options are equal .

Earning per share = Net Income /shares outstanding

[EBIT -interest ][1-tax] /shares outstanding = [EBIT -interest ][1-tax] /shares outstanding

[EBIT -0][1-.50]/300 = [EBIT - 600][1-.50]/200

.50 EBIT /300 = [EBIT-600]*.50 /200

.50 EBIT /300 = .50EBIT - 300 /200

200(.50EBIT)/300 = .50 EBIT -300

.66667(.50 EBIT ) = .50 EBIT -300

.33333 EBIT = .50 EBIT -300

300 = .50 EBIT -.33333 EBIT

300 = .16667 EBIT

300/.16667 =EBIT

EBIT = $ 1799.96      [rounded to 1800]

c)Earning per share under alternative 1 = [1800-0][1-.50] /300

                     = [1800-0]*.50/300

                    = 900/300

                  = $ 3 per share

Alternative 1 (common shares) Alternative2(Debt) EBIT 2400 2400 Less:Interest 0 (600)       [10000*.06] EBT 2400 1800 less:Tax (1200)             [2400*.50] (900)             [1800*.50] Net Income 1200 900 number of shares outstanding 200+100=300 200 Earning per share 1200/300 =$ 4 per share 900/200 = $ 4.5 per share

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