a)
To compute: The highest EPS and the lowest EPS.
Introduction:
The leverage refers to the borrowing of amount or debt to be utilized for a purchase of an equipment, inventory, and other assets of the company.
a)
Answer to Problem 6QP
The all-equity plan has the highest EPS and the lowest EPS is in Plan II.
Explanation of Solution
Given information:
Company H compares two various capital structures, Plan I, and Plan II. The first plan will result in $13,000 shares of stock and $130,500 in the debt. The second plan will result in $10,400 shares of stock and $243,600 in debt. The rate of interest on debt is 10%. The EBIT is $56,000. The plan of equity will result in the stock outstanding of $16,000 shares.
Formula to calculate the payment of interest:
Compute the payment of interest:
Hence, the payment of interest under Plan I is $13,050.
Compute the payment of interest:
Hence, the payment of interest under Plan II is $24,360.
Formula to calculate the NI (Net Income):
Compute NI for each plan:
Hence, the net income under Plan I is $42,950.
Hence, the net income under Plan II is $31,640.
Formula to compute the EPS:
Compute the EPS:
Hence, the EPS for plan I is $3.03.
Hence, the EPS for plan II is $3.04.
Hence, the EPS for plan III is $3.50.
Table showing the income statement for each plan:
I | II | All-equity | |
EBIT | $56,000 | $56,000 | $56,000 |
Interest | 13,050 | 24,360 | 0 |
NI | $42,950 | $31,640 | $56,000 |
EPS | $ 3.30 | $ 3.04 | $ 3.50 |
Hence, the all-equity plan has the highest EPS and the lowest EPS is in Plan II.
b)
To calculate: The break-even level of EBIT for Plan I and Plan II compared with the all-equity plan and identify whether any one of the plans is greater than the other with a reason.
Introduction:
The leverage refers to the borrowing of amount or debt to be utilized for a purchase of an equipment, inventory, and other assets of the company.
b)
Answer to Problem 6QP
The break-even level of EBIT is the same between all equity-plan, Plan I, and Plan II as it is an M&M proposition.
Explanation of Solution
Given information:
Company H compares two various capital structures, Plan I, and Plan II. The first plan will result in $13,000 shares of stock and $130,500 in the debt. The second plan will result in $10,400 shares of stock and $243,600 in debt. The rate of interest on debt is 10%. The EBIT is $56,000. The plan of equity will result in the stock outstanding of $16,000 shares.
Explanation:
The break-even level of EBIT happens when the plans of capitalization lead to have the same EPS. Thus, the formula to compute EPS is as follows:
Formula to calculate the break-even level of EBIT:
Where,
RDD denotes the payment of interest
The above equation computes the payment of interest (RDD) and subtracts it from EBIT, which gives the net income. The net income divided by the outstanding shares gives the EPS. The interest is zero for all-equity plan. To compute the break-even level of EBIT for Plan I and all-equity plan, set the equations equal to each other.
Equation to solve for break-even level of EBIT under Plan I:
Equation to solve for break-even level of EBIT under all equity plan:
Solve the above two equations:
Hence, the break-even level of EBIT between Plan I and all-equity plan is $69,600.
Equation to solve for break-even level of EBIT under Plan II:
Solve the above equation with the equation of all-equity plan:
Hence, the break-even level of EBIT between Plan II and all-equity plan is $69,600.
c)
To calculate: The EBIT to identify the identical EPS under Plan I and Plan II.
Introduction:
The leverage refers to the borrowing of amount or debt to be utilized for a purchase of an equipment, inventory, and other assets of the company.
c)
Answer to Problem 6QP
The break-even level of EBIT is the same between Plan I and Plan II due to M&M proposition.
Explanation of Solution
Given information:
Company H compares two various capital structures, Plan I, and Plan II. The first plan will result in $13,000 shares of stock and $130,500 in the debt. The second plan will result in $10,400 shares of stock and $243,600 in debt. The rate of interest on debt is 10%. The EBIT is $56,000. The plan of equity will result in the stock outstanding of $16,000 shares.
Equation to solve for break-even level of EBIT under Plan I:
Equation to solve for break-even level of EBIT under Plan II:
Solve the above two equations:
Hence, the break-even level of EBIT between two plans is $69,600.
d)
To calculate: The highest EPS and the lowest EPS, the break-even level of EBIT of Plan I and Plan II compared with the all-equity plan, and the EBIT to identify the identical EPS under Plan I and Plan II if the corporate rate of tax is 40%.
Introduction:
The leverage refers to the borrowing of amount or debt to be utilized for a purchase of an equipment, inventory, and other assets of the company.
d)
Answer to Problem 6QP
Including the corporate rate of tax, the break-even level of EBIT is the same as the additional taxes decreases with the three plans by the same percentage. Hence, they do not change relatively with one another.
Explanation of Solution
Given information:
Company H compares two various capital structures, Plan I, and Plan II. The first plan will result in $13,000 shares of stock and $130,500 in the debt. The second plan will result in $10,400 shares of stock and $243,600 in debt. The rate of interest on debt is 10%. The EBIT is $56,000. The plan of equity will result in the stock outstanding of $16,000 shares.
Formula to calculate the payment of interest:
Compute the payment of interest:
Hence, the payment of interest under Plan I is $13,050.
Compute the payment of interest:
Hence, the payment of interest under Plan II is $24,360.
Formula to calculate taxes:
Compute taxes for each plan:
Hence, the tax for Plan I is $17,180.
Hence, the tax for Plan II is $12,656.
Hence, the tax for all-equity plan is $22,400.
Formula to calculate the NI (Net Income):
Compute NI for each plan:
Hence, the net income under Plan I is $25,770.
Hence, the net income under Plan II is $18,984.
Hence, the net income under all-equity plan is $33,600.
Formula to compute the EPS:
Compute the EPS:
Hence, the EPS for plan I is $1.98.
Hence, the EPS for plan II is $1.83.
Hence, the EPS for all-equity plan is $2.10.
Table showing the income statement under each plan:
I | II | All-equity | |
EBIT | $56,000 | $56,000 | $56,000 |
Interest | 13,050 | 24,360 | 0 |
Taxes | 17,180 | 12,656 | 22,400 |
NI | $25,770 | $18,984 | $ 33,600 |
EPS | $1.98 | $1.83 | $2.10 |
Hence, the all-equity plan has the highest EPS and the lowest EPS is in Plan II.
Formula to calculate the break-even level of EBIT under Plan I:
Where,
RD denotes the payment of interest
D denotes the debt amount
TC is the corporate tax rate
Note: The above equation is equal to the equation used before, except an addition of taxes.
Equation to solve for break-even level of EBIT under Plan I:
Equation to solve for break-even level of EBIT under all equity plan:
Solve the above two equations:
Hence, the break-even level of EBIT between all-equity plan and Plan II is $69,600.
Equation to solve for break-even level of EBIT under Plan II:
Solve the above equation with the equation of all-equity plan:
Hence, the break-even level of EBIT between Plan II and all-equity plan is $69,600.
Formula to calculate the break-even level of EBIT under Plan I:
Equation to solve for break-even level of EBIT under Plan II:
Solve the above two equations:
Hence, the break-even level of EBIT between Plan I and Plan II is $69,600.
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