A5Q6 DEF Company is comparing three different capital structures. Plan I would r
ID: 2807480 • Letter: A
Question
A5Q6
DEF Company is comparing three different capital structures. Plan I would result in 800 shares of stock and $9,000 in debt. Plan II would result in 700 shares of stock and $13,500 in debt. Plan III is an all-equity plan and would result in 1,000 shares of stock. The firm's EBIT will be $8,000 per year until infinity. The interest rate on the debt is 10%. a. Ignoring taxes, compute the EPS for each of the three plans. Which of the three plans has the highest EPS? Which has the lowest? b. Compute the break-even EBIT that will cause the EPS on Plan I to be equal to the all-equity EPS. C. Compute the break-even EBIT that will cause the EPS on Plan II to be equal to the all-equity EPS. d. Compare your results from parts (b) and (c) above. Is one higher than the other? Why? e. Ignoring taxes, what is the break-even EBIT that will cause the EPS on Plan I to be equal to the EPS on Plan II? What conclusions do you reach when you compare the outcomes of parts (b), (c), and (e) above?Explanation / Answer
a) EPS = (EBIT - Debt Interest)/Number of shares
Plan 1 : EPS = (8000 - 9000*0.1)/800 = 7100/800 = 71/8 = 8.875
Plan 2 : EPS = (8000 - 13500*0.1)/700 = 6650/700 = 9.5
Plan 3 : EPS = (8000)/1000 = 8
b) If Plan 1 becomes all equity, EPS = EBIT/Number of shares
8.875*800 = EBIT
7100 = EBIT
c) If Plan 2 becomes all equity, EPS = EBIT/Number of shares
9.5*700 = EBIT
6650 = EBIT
d) EBIT in plan 1 is higher than plan 2 ... (ALL equity EBIT)
e) (EBIT-900)/800 = (EBIT-1350)/700
Let EBIT be x
7x-6300= 8x - 10800
x= 4500
EBIT in b > EBIT in c > EBIT in e