Blue Stripes Co. is comparing two different capital structures. Plan I would res
ID: 2689297 • Letter: B
Question
Blue Stripes Co. is comparing two different capital structures. Plan I would result in 8,700 shares of stock and $399,000 in debt. Plan II would result in 12,500 shares of stock and $239,400 in debt. The interest rate on the debt is 11 percent. Requirement 1: Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $53,900. The all-equity plan would result in 18,200 shares of stock outstanding. Compute the EPS for each plan. (Do not include the dollar signs ($). Round your answers to 2 decimal places (e.g., 32.16).) Find EPS Plan I $ Plan II $ All-equity plan $ Requirement 2: (a) In req. (1), what is the break-even level of EBIT for Plan I as compared to that for an all-equity plan? (Do not include the dollar sign ($).) EBIT $ (b) In req. (1), what is the break-even level of EBIT for Plan II as compared to that for an all-equity plan? (Do not include the dollar sign ($).) EBIT $ Requirement 3: Ignoring taxes, at what level of EBIT will EPS be identical for Plans I and II? (Do not include the dollar sign ($).) EBIT $Explanation / Answer
Different organizations have different financing decision and accordingly the capital structure of the organization differs. The level of leverage (debt-equity ratio) effects the earning per share of the organization. In general the capital structure of the organization is made of two components debt and equity. Debt holders are paid annual coupon or there investment in the organization and the equity shareholders are paid return in the form of dividend and price appreciation. The income which is left after payment of interest to the debt holders and taxes are known earnings of the organization. The level of earnings per share varies with the change in capital structure but the level of EBIT remains constant assuming other things are constant
The level of EBIT at which the earning per share under all the options are same is known as break even EBIT. With the increase in debt in capital structure the fixed charge of the organization increase which reduces the earnings per share of the organization on the other hand the number of outstanding shares fall which increases the EPS. Similarly when debt is reduced the EPS increases and outstanding shares rises thereby reducing the EPS. Thus both forces act in opposite direction.
Plan I would result in 8,700 shares of stock and $399,000 in debt
The interest rate on the debt is 11 percent.
plan 1
let EBIT = x
reduction due to debt : Interest [399000*11%] = 43890
a)Profit before tax = (x – 43890)
b)Number of shares = 8700
EPS [a/b] (x – 43890)/8700
Plan II would result in 12,500 shares of stock and $239,400 in debt.
plan 2
EBIT = x
reduction due to debt : Interest [239400*11%] = 26334
a)Profit before tax = (x – 26334)
b)Number of shares = 12500
EPS [a/b] (x – 26334)/12500
taking EBIT = $53,900
plan1 yields EPS1 = (53900-43890)/8700 = 1.15
plan yields EPS2 = (53900-26334)/12500 =2.205