Lenow\"s Drug Store and Hall\'s Pharmaceuticals are competitors. The seperate capital structure
for Lenow and Hall are presented as follows
Lenow Hall
Debt @ 10% $ 100,000 $200,000
Common Stock, $10 par 200,000 Common Stock, $10 par 100,000
------------ --------------
Total 300,000 300,000
Common Share 20,000 Common Share 10,000
a Complete the following table given earnings before interest and taxes of $20,000, $30,000, and
$120,000. Assume the tax rate is 30 percent. (Leave no cells blan - be certain to enter \"0\"
wherever required.) Round answers to 2 decimal places.
EBIT Total Assets EBIT/TA Lenow EPS Halls EPS
20,000 300,000
30,000 300,000
120,000 300,000
What is the relationship between the EPS of the two firms
b-1 What is EBIT/TA rate -----------------------%
b-2 What is cost of Debt -------------------------%
b-3 State the relationship between earnings per share and the level of EBIT
c. - If the cost of debt went up to 12 percent and all other factors remained equal, what will be
the break even point?
Solution
1) EBIT/TA- 20000/300000 = 6.67%
30000/300000=10%
120,000/300000=40%
2) The after-tax cost of the debt is computed as follows: $10,000 paid to the lender minus $3,000
of income tax savings equals a net cost of$7,000 per year on the $100,000 loan. This means the
after-tax cost is 7% ($7,000 divided by $100,000).
3)
While deciding on the appropriate capital structure for an organisation, the first thing is to
understand the affect on Earning Per Share (EPS) due to the changes in Earning Before Interest
and Taxes (EBIT) under different financing alternatives.
The relationship between EBIT and EPS is as follows:
(EBIT – I) (1-t)
EPS = ---------------------
n
Where,
EBIT = earnings before interest and taxes
EPS = earnings per share
I = interest
t = tax rate
n = number of equity shares
Break-even EBIT level
Break-even EBIT level is the indifferent point where EPS under alternative financing plan is the
same. Mathematically, the break-even EBIT level is:
(EBIT* - I1) (1 – t) (EBIT* - I2) (1- t)
--------------------------- = -------------------------
n1 n2
Where,
EBIT* = indifference point between the two alternative financing plans
I1, I2 = interest expenses
t = income-tax rate
n1, n2 = number of equity shares outstanding after adopting financing plans 1and 2
Illustration
Consider a company XYZ ltd., which is considering the following two financing options:
Applying the above equation for XYZ ltd. (considering the tax rate is 50%), we get,
(EBIT* - 0) (0.5) (EBIT* - 1,400,000) (0.5)
----------------------- = ------------------------------------
2,000,000 1,400,000
EBIT* = Rs.2,800,000
Therefore, the break-even EBIT level, is Rs.2,800,000 for XYZ ltd. If the present EBIT level of
XYZ ltd is more than the break-even EBIT, then it would be better off to finance the new project
by issuing bond. The equity finance option will be favourable if the present level of EBIT is
below the break-even EBIT level..
Lenows Drug Store and Halls Pharmaceuticals are competitors. The.pdf
1. Lenow"s Drug Store and Hall's Pharmaceuticals are competitors. The seperate capital structure
for Lenow and Hall are presented as follows
Lenow Hall
Debt @ 10% $ 100,000 $200,000
Common Stock, $10 par 200,000 Common Stock, $10 par 100,000
------------ --------------
Total 300,000 300,000
Common Share 20,000 Common Share 10,000
a Complete the following table given earnings before interest and taxes of $20,000, $30,000, and
$120,000. Assume the tax rate is 30 percent. (Leave no cells blan - be certain to enter "0"
wherever required.) Round answers to 2 decimal places.
EBIT Total Assets EBIT/TA Lenow EPS Halls EPS
20,000 300,000
30,000 300,000
120,000 300,000
What is the relationship between the EPS of the two firms
b-1 What is EBIT/TA rate -----------------------%
b-2 What is cost of Debt -------------------------%
b-3 State the relationship between earnings per share and the level of EBIT
c. - If the cost of debt went up to 12 percent and all other factors remained equal, what will be
the break even point?
Solution
1) EBIT/TA- 20000/300000 = 6.67%
30000/300000=10%
120,000/300000=40%
2) The after-tax cost of the debt is computed as follows: $10,000 paid to the lender minus $3,000
of income tax savings equals a net cost of$7,000 per year on the $100,000 loan. This means the
after-tax cost is 7% ($7,000 divided by $100,000).
3)
While deciding on the appropriate capital structure for an organisation, the first thing is to
understand the affect on Earning Per Share (EPS) due to the changes in Earning Before Interest
and Taxes (EBIT) under different financing alternatives.
The relationship between EBIT and EPS is as follows:
2. (EBIT – I) (1-t)
EPS = ---------------------
n
Where,
EBIT = earnings before interest and taxes
EPS = earnings per share
I = interest
t = tax rate
n = number of equity shares
Break-even EBIT level
Break-even EBIT level is the indifferent point where EPS under alternative financing plan is the
same. Mathematically, the break-even EBIT level is:
(EBIT* - I1) (1 – t) (EBIT* - I2) (1- t)
--------------------------- = -------------------------
n1 n2
Where,
EBIT* = indifference point between the two alternative financing plans
I1, I2 = interest expenses
t = income-tax rate
n1, n2 = number of equity shares outstanding after adopting financing plans 1and 2
Illustration
Consider a company XYZ ltd., which is considering the following two financing options:
Applying the above equation for XYZ ltd. (considering the tax rate is 50%), we get,
(EBIT* - 0) (0.5) (EBIT* - 1,400,000) (0.5)
----------------------- = ------------------------------------
2,000,000 1,400,000
EBIT* = Rs.2,800,000
Therefore, the break-even EBIT level, is Rs.2,800,000 for XYZ ltd. If the present EBIT level of
XYZ ltd is more than the break-even EBIT, then it would be better off to finance the new project
by issuing bond. The equity finance option will be favourable if the present level of EBIT is
below the break-even EBIT level.
