Question

Sanborn Corp. is comparing two different capital structures. Plan I would result in 2,300 shares of stock and $22,560 in debt. Plan II would result in 1,400 shares of stock and $47,940 in debt. The interest rate on debt is 10 percent.

a) Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $7,000. The all-equity plan would result in 3,100 shares of stock outstanding. Which of the three plans has the highest EPS? The lowest?

b) In part (a), what are the break-even levels of EBIT for each plan as compared to that for an allequity plan? Is one higher than the other? Why?

Answer 1

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Answer:

a.

EPS of Plan I = (EBIT-interest)*(1-t)/number of shares

EPS of Plan I = (7000-10%*22560)/2300= 2.06

EPS of Plan II= (7000-10%*47940)/1400=1.58

EPS of all equity = 7000/3100= 2.26

All equity plan has highest EPS and Plan II has lowest EPS

b. Comparing Plan 1 and all equity

(EBIT1-10%*22560)/2300 = EBIT1/3100

break-even levels of EBIT1 = 8742

Comparing Plan 2 and all equity

(EBIT2-10%*47940)/1400 = EBIT2/3100

break-even levels of EBIT2 = 8742

break-even EBIT 2 is equal to EBIT-1

The break-even levels of EBIT are the same because of M&M Proposition I.