Question

Franklin 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 315,000 shares of stock outstanding. Under Plan II, there would be 225,000 shares of stock outstanding and $4.14 million in debt outstanding. The interest rate on the debt is 10% and there are no taxes.

A-If EBIT is $750,000, which plan will result in the higher EPS?

B-What is the break-even EBIT?

Answer 1

A)

Plan 1:

EPS = EBIT / shares

EPS = 750,000 / 315,000

EPS under plan 1 = 2.38

Plan 2:

Interest = 4,140,000 * 0.1 = 414,000

EPS = (EBIT - interest) / shares

EPS = (750,000 - 414,000) / 225,000

EPS under plan 2 = 1.49

Plan 1 has higher EPS

B)

EBIT/315,000 = [EBIT – 414,000)]/225,000

225,000(EBIT/315,000) = EBIT – 414,000

EBIT225,000/315,000 = EBIT – 414,000

EBIT0.71429 = EBIT – 414,000

414,000 = EBIT – EBIT0.71429

414,000 = EBIT0.28571

EBIT = 414,000 / 0.28571

EBIT = 1,449,021.74

Break Even EBIT is  1,449,021.74