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Homework answers / question archive / Source of capital Long-term debt Common stock Structure A $95,000 at 15
Source of capital Long-term debt Common stock Structure A $95,000 at 15.1% coupon rate 4,700 shares Structure B $190,000 at 16.1% coupon rate 2,350 shares
a. Calculate two EBIT-EPS coordinates for each of the structures by selecting any two EBIT values and finding their associated EPS values. b. Plot the two capital structures on a set of EBIT-EPS axes. C. Indicate over what EBIT range, if any, each structure is preferred. d. Discuss the leverage and risk aspects of each structure e. If the firm is fairly certain that its EBIT will exceed $75,000, which structure would you recommend? Why?
Answer to Part a
| Stucture | A | Stucture | B | |||
| Long Term Debt | 95,000 | Long Term Debt | 190,000 | |||
| Coupon Rate | 15.10% | Coupon Rate | 16.10% | |||
| Common Stock | 4,700 | Common Stock | 2,350 | |||
| Tax | 40% | Tax | 40% | |||
| Structure A | Structure B | |||||
| EBIT | 50,000 | 60,000 | EBIT | 50,000 | 60,000 | |
| Less: Interest | 14,345 | 14,345 | Less: Interest | 30,590 | 30,590 | |
| Profit before tax | 35,655 | 45,655 | Profit before tax | 19,410 | 29,410 | |
| Tax @40% | 14,262 | 18,262 | Tax @40% | 7,764 | 11,764 | |
| PAT | 21,393 | 27,393 | PAT | 11,646 | 17,646 | |
| EPS | 4.55 | 5.83 | EPS | 4.96 | 7.51 | |
Answer to Part b
Answer to Part c
To calculate the EBIT range, we need to know the indifference point between Structure A and B
Indifference point is the level of EBIT where EPS is same in both Structure A and Structure B
Let us assume EBIT to be x
| A | B | |
| EBIT | x | x |
| Less: Interest | 14,345 | 30,590 |
| PBT | (x-14,345) | (x-30,590) |
| Tax @40% | 40%*(x-14,345) | 40%*(x-30,590) |
| PAT | 60%*(x-14,345) | 60%*(x-30,590) |
| EPS | 60%*(x-14,345)/4700 | 60%*(x-30,590)/2350 |
Since EPS is same in both the case,
Hence, 60%*(x-14,345)/4700 = 60%*(x-30,590)/2350
Solving the above equation, we get x = $46,835
If EBIT is $46,835, EPS in both the Structure A and B is same.
If EBIT is below $46,835, the structure A is preferred.
If EBIT is above $46,835, the structure B is preferred.
To show this refer below:
Assuming EBIT is $45,000
| Structure A | Structure B | |
| EBIT | 45,000 | 45,000 |
| Less: Interest | 14,345 | 30,590 |
| Profit before tax | 30,655 | 14,410 |
| Tax @40% | 12,262 | 5,764 |
| PAT | 18,393 | 8,646 |
| EPS | 3.91 | 3.68 |
Since, EPS is higher in Structure A, Structure A is preferred when EBIT is below indiferrence point
Assuming EBIT is $49,000
| Structure A | Structure B | |
| EBIT | 49,000 | 49,000 |
| Less: Interest | 14,345 | 30,590 |
| Profit before tax | 34,655 | 18,410 |
| Tax @40% | 13,862 | 7,364 |
| PAT | 20,793 | 11,046 |
| EPS | 4.42 | 4.70 |
Since, EPS is higher in Structure B, Structure B is preferred when EBIT is above indiferrence point.
Answer to Part d
Structure A: It has lower return when EBIT increases and has less risk because of low interest expense
Structure B: It has higher return when EBIT increases and is more risky because of high interest expense
Answer to Part e
If a firm is fairly certainly that EBIT will exceed $75,000, Structure B is preferred because EPS is higher in structure B.
please see the attached file.
