Question

Kyle Corporation is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, the company would have 715,000 shares of stock outstanding. Under Plan II, there would be 465,000 shares of stock outstanding and $6.75 million in debt outstanding. The interest rate on the debt is 7 percent, and there are no taxes.

a. Assume that EBIT is $1.6 million. Compute the EPS for both Plan I and Plan II.
b. Assume that EBIT is $3.1 million. Compute the EPS for both Plan I and Plan II.
c. What is the break-even EBIT?

Answer 1

EPS = (Net income - Dividends) / Average number of share

a. Plan 1

Number of share = 715,000

EPS = $1,600,000/715,000

EPS = 2.23 (EBIT = Net Income as Interest and tax are 0)

Plan 2

Net income = EBIT = $1.6 million = $1,600,000

Interest = 0.07*$6,750,000 = $472,500

EBT = $1,600,000 - $472,500 = $1,127,500

Tax = 0

Net Income = 1,127,500 (1)

Number of share = 465,000

EPS = $1,127,500/465000

EPS = 2.42 (Net Income from 1)

b. Plan 1

EPS = $3,100,000/715000 = $4.33

Plan 2

When EBIT = $3,100,000

Interest = 0.07*$6,750,000 = $472,500

Net Income = $3,100,000 - $472,500 = $2,627,500

EPS = $2,627,500/465,000

EPS = 5.65 (From 2)

c. Plan 1 EBIT = Plan 2 EBIT to calculate break-even EBIT

EBIT/715,000 = (EBIT - 0.07*$6,750,000)/465,000

EBIT = $1,351,350