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Harden Hardware Limited is considering a change to its current capital structure
Harden Hardware Limited is considering a change to its current capital structure.
The current capital structure (Plan I) is all equity with 210,000 common shares outstanding.
Under Plan II, the company would issue debt to buy back shares, leaving 150,000 shares of common stock
outstanding and $2,280,000 in debt at an interest rate of 8%. The tax rate is 40%
a) If EBIT is $500,000, Which plan will result in the highest EPS? Show your work. (4 marks)
b) If EBIT is $750,000, Which plan will result in the highest EPS? Show your work. (4 marks)
c) Calculate the breakeven EBIT for each plan. (2 marks)
d) Calculate the indifference EBIT (4 marks)
e) Calculate EPS for each plan at this level of EBIT (2 marks)
Expert Solution
Plan 1
EQUITY SHARES = 210,000
no debt
Plan 2
Equity shares = 150,000
Debt = $ 2,280,000 at 8%
Tax rate for both plans 40%
So
Interest obligations for the debt = 8% of 2,280,000 = 182,400
Part a
EBIT 500,000
Calculation are as follows
Plan 1
|
EBIT |
5,00,000 |
|
les Interest |
|
|
EBT |
5,00,000 |
|
Less Tax |
200000 |
|
EAT |
3,00,000 |
|
No of shares |
2,10,000 |
|
EPS |
1.43 |
Taxes are calculate don the EBT after interest is deducted from the EBIT . Tax rate given is 40%
Plan 2
|
EBIT |
5,00,000 |
|
les Interest |
182400 |
|
EBT |
3,17,600 |
|
Less Tax |
127040 |
|
EAT |
1,90,560 |
|
No of shares |
150000 |
|
EPS |
1.27 |
So Plan 1 is having higher EPS
Part B
When EBIT = 750,000
For Plan 1
|
EBIT |
7,50,000 |
|
les Interest |
|
|
EBT |
7,50,000 |
|
Less Tax |
300000 |
|
EAT |
4,50,000 |
|
No of shares |
2,10,000 |
|
EPS |
2.14 |
For Plan 2
|
EBIT |
7,50,000 |
|
les Interest |
182400 |
|
EBT |
5,67,600 |
|
Less Tax |
227040 |
|
EAT |
3,40,560 |
|
No of shares |
1,50,000 |
|
EPS |
2.27 |
Interest obligations on the debt is 182,400 as calculated above
So Plan 2 is having higher EPS
No in order to break even , both the financing plans have the similar set of EPS , so we are indifferent between it ,
So
Plan 1 EPS = Plan 2 EPS
EBIT / NO OF SHARES = EBIT – INTEREST / NO OF SHARES
= EBIT / 210,000 = (EBIT – 182,400) / 150,000
OR
60,000 EBIT = 182400 * 210000
Solving we get
EBIT = 638,400
So we are indifferent between the plans EPS at an EBIT level of 638400
EPS of plans
Plann 1
|
EBIT |
6,38,400 |
|
les Interest |
|
|
EBT |
6,38,400 |
|
Less Tax |
255360 |
|
EAT |
3,83,040 |
|
No of shares |
2,10,000 |
|
EPS |
1.82 |
Plan 2
|
EBIT |
6,38,400 |
|
les Interest |
182400 |
|
EBT |
4,56,000 |
|
Less Tax |
182400 |
|
EAT |
2,73,600 |
|
No of shares |
1,50,000 |
|
EPS |
1.82 |
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