Question

Franklin corporation is comparing two different capital structures, an all equity plan (plan 1) and a levered plan (plan 2). Under plan 1, the company would have 315,000 shares of stock outstanding. Under plan 2, there would be 225,000 shares outstanding and $4.14 million in debt outstanding. The interest rate on the debt is 10 percent and there are no taxes.
A)If EBIT is $750,000, which plan will result in the highest EPS?

B)What is the break even EBIT?

Answer 1

Answer:

All equity firm will get 2.38 EPS while leverage firm 1.49

Break Even EBIT 1,449,000

Explanation:

EBIT 750,000

interest rate 10%

(there are no taxes thus, we do not make the distinction between after and pre-tax cost of debt)

4,140,000 x 0.1 = 414,000  interest expense

net income 336,000

outstanding shares 225,000

$EPS = \frac{income-}{outstanding \: common \: stock}$

EPS 1.49333

All equty: 750,000 / 315,000 = 2,38

Break Even EBIT:

The point at which is indiferent to be equity or levered firm:

Levered Firm EPS = Equity Firm EPS

$(EBIT - 414,000)/225,000 = EBIT / 315,000\\EBIT/225,000 -414,000/225,000 = EBIT/315,000\\EBIT/225,000 - EBIT/315,000 = 414,000/225,000\\EBIT = 1.84 / (1/225,000 - 1/315,000)$

Break Even EBIT 1,449,000