Question

Gerrell Corp. is comparing two different capital structures. Plan I would result in 18,000 shares of stock and $95,000 in debt. Plan II would result in 14,000 shares of stock and $190,000 in debt. The interest rate on the debt is 5 percent. Compare both of these plans to an all-equity plan assuming that EBIT will be $90,000. The all-equity plan would result in 22,000 shares of stock outstanding. Assuming that the corporate tax rate is 40 percent, what is the EPS for each of these plans

Answer 1

Plan I

Number of share outstanding = 18,000

Value of debt = $95,000

Interest on debt = $95,000*5% = $4,750

EBIT = $90,000

Net Income = ($90,000 - $4,750)*(1 - 40%) = $85,250*60% = $51,150

EPS in case of plan I = $51,150 / 18,000 = $2.84.

Plan II

Number of share outstanding = 14,000

Value of debt = $190,000

Interest on debt = $190,000*5% = $9,500

EBIT = $90,000

Net Income = ($90,000 - $9,500)*(1 - 40%) = $80,500*60% = $48,300

EPS in case of plan II = $84,300 / 14,000 = $3.45

All equity Plan

Net Income = $90,000 * (1 - 40%) = $54,000

EPS in case of all equity plan = $54,000 / 22,000 = $2.45.