Interest Under Debt Alternative $50 (Million) × 10% $5 (Million) EPS (Debt Financing) EPS (Equity Financing)
Interest Under Debt Alternative $50 (Million) × 10% $5 (Million) EPS (Debt Financing) EPS (Equity Financing)
Interest Under Debt Alternative $50 (Million) × 10% $5 (Million) EPS (Debt Financing) EPS (Equity Financing)
Emco Products has a present capital structure consisting only of common stock (10
million shares). The company is planning a major expansion. At this time, the company is
undecided between the following two financial plans (assume a 40 percent marginal tax
rate):
Plan 2 (Debt financing). Under this plan, $50 million of 10 percent long term debt
will be sold.
One piece of information the company desires for its decision analysis is an EBIT-EPS
analysis.
6EBIT = 9EBIT - 45
3 EBIT = 45
EBIT = $15
d. What happens to the indifference point if the interest rate on debt remains constant and
the common stock sales prices increases?
Plan 1 (Equity Financing). Under this plan, $2 million common shares will be
sold at $10 each.
Plan 2 (Debt equity financing). Under this plan, $10 million of 12 percent long-
term debt and 1 million common shares at $10 each will be sold.
Plan 1 Plan 2
I 0 1.2
c. What factors should the company consider in deciding which financing plan to adopt?
1. The plan's effect on the company's stock price (difficult to determine in practice).
Adopt plan 2 if the company can be reasonably sure that EBIT will not drop too much in
e. Suppose Morton adopts Plan 2, and the Boston facility initially operates at an annual
EBIT level of $6 million. What is the times interest earned ratio?
6. Moon and Chittenden are considering a new Internet venture to sell used textbooks.
The project requires $300,000 in financing. Two alternatives have been proposed.
Plan 1 (Common equity financing). Sell 30, 000 shares of stock at a net price of
$10 per share.
Plan 2 (Debt equity financing). Sell a combination of 15,000 shares of stock at a
net price of $10 per share and $150,000 of long-term debt at a pretax interest rate of 12
percent.
Plan A
Debt= $0
Equity= $300,000
# of shares= 30,000
Interest rate= 12.00%
Interest expense= $0.00
Plan B
Debt= $150,000
Equity= $150,000
# of shares= 15,000
Interest rate= 12.00%
Interest expense= $18,000 =12.% x $150,000.
EPS = (EBIT - Interest)x (1-Tax rate) / # of shares
EPS
Plan A : (EBIT-0) (1-0.4)/30000
Plan B : (EBIT-18000) (1-0.4)/15000
For point of indifference EPS under two plans should be eaual
or
(EBIT-0) (1-0.4)/30000 = (EBIT-18000) (1-0.4)/15000
b. If the firms EBIT next year has an expected value of $25,000, which plan would you
recommend assuming maximizing EPS is a valid objective?
Below the indifference point, the plan with lower debt is better
Hence opt for Plan A as it would give a higher EPS
Check:
EBIT= $25,000
Plan A
Debt $0
Plan B
Debt $150,000