Bebe Metals is planning a major expansion program requiring $10,000,000 in finan
ID: 2543700 • Letter: B
Question
Bebe Metals is planning a major expansion program requiring $10,000,000 in financing. Bebe’s may sell bonds with a 6% coupon rate or sell 200,000 shares of common stock to get the needed funds. After the expansion there is a 50% probability of EBIT (Earnings Before Interest and Taxes) being $5 million, a 20% probability of it being $3 million and a 30% probability of it being $4 million. The following data was taken from the firm’s pre-expansion income statement:
Interest expense $200,000
Tax Rate 40%
Common shares outstanding 350,000
Calculate the EPS based on the expected EBIT under each alternative.
Which plan would you chose at this level of EBIT?
Compute the DFL (Degree of Financial Leverage) at the expected level of EBIT under each financing alternative. If EBIT increased by 10%, what would the new EPS be under each alternative?
Explanation / Answer
1. EPS based on expected EBIT under each alternative method. Expected EBIT after expansion - (Amount in $) Profit Probablity Expected profit (A) (B) (A*B) 50,00,000 0.5 25,00,000 30,00,000 0.2 6,00,000 40,00,000 0.3 12,00,000 EBIT 43,00,000 Calculation of EPS under both alternatives (Amount in $) Alternative 1 Alternative 2 Expected EBIT 43,00,000 43,00,000 less : Intetest expense 2,00,000 2,00,000 Less: Interest on Bonds (10,000,000 * .08) 8,00,000 - 33,00,000 41,00,000 Less : Tax @ 40% 13,20,000 16,40,000 Profit After tax (A) 19,80,000 24,60,000 Existing no. of shares 3,50,000 3,50,000 New shares - 2,00,000 Total number of shares (B) 3,50,000 5,50,000 EPS (A/B) 5.66 4.47 2. Based on EPS, Alternative one of issuing of Bonds is Prefereable. 3. Degree of Financial leverage = EBIT/(EBIT - Interest) (Amount in $) Alternative 1 Alternative 2 EBIT (A) 43,00,000 43,00,000 Interest (B) 10,00,000 2,00,000 EBIT - Interest {C = A-B} 33,00,000 41,00,000 Degree of Financial leverage (A/C) 1.30 1.05 4. Revised expected EPS, If EBIT increased by 10% (Amount in $) Revised EBIT (43,00,000*1.1) 47,30,000 Alternative 1 Alternative 2 Expected EBIT 47,30,000 47,30,000 less : Intetest expense 2,00,000 2,00,000 Less: Interest on Bonds (10,000,000 * .08) 8,00,000 - 37,30,000 45,30,000 Less : Tax @ 40% 14,92,000 18,12,000 Profit After tax (A) 22,38,000 27,18,000 Existing no. of shares 3,50,000 3,50,000 New shares - 2,00,000 Total number of shares (B) 3,50,000 5,50,000 EPS (A/B) 6.39 4.94