Question

Katie’s Kitchens is planning a major expansion program requiring $10,000,000 in financing. Katie’s may sell bonds with a 6% coupon rate or sell 200,000 shares of common stock to get the needed funds. After the expansion there is a 50% probability of EBIT (Earnings Before Interest and Taxes) being $5 million, a 20% probability of it being $3 million and a 30% probability of it being $4 million.

The following data was taken from the firm’s pre-expansion income statement: Interest expense $200,000 Tax Rate 40% Common shares outstanding 350,000

a) Calculate the EPS based on the expected EBIT under each alternative.

b) Which plan would you chose at this level of EBIT? (1 mark)

c) Compute the DFL (Degree of Financial Leverage) at the expected level of EBIT under each financing alternative. If EBIT increased by 10%, what would the new EPS be under each alternative?

d) What level of EBIT would yield the same EPS for the stock and debt alternatives?

e) What EPS corresponds to this level of EBIT?

f) Recalculate the indifference EBIT if instead of issuing 200,000 shares of common stock to raise the funds (the second option), the company issues 100,000 common shares and 100,000, $50 par, 3% preferred shares.

Answer 1

As per rules I am answering the first 4 sub parts of the question

a)

PART 1

Expected EBIT= 0.5*$5m+ 0.2*3m + 0.3*4 m = $4.3 million

Alternative 1: Sell Bonds

Interest= 6%*10 m = $600,000

PBT= EBIT- Interest

= 4300,000- 200,000- 600,000 = 3500,000

Net Income= PBT*(1-Tax)

= 3500,000*(1-0.4)

=2100,000

Common shares outstanding= 350,000

EPS= Net Income/ shares outstanding

= 2100,000/ 350000

=$6

PART 2

Alternative 2:Sell stock

EBIT= $4300,000

Net Income= (EBIT-Interest)*(1-Tax)

= (4300,000-200000)*(1-0.4)

= 2,460,000

Shares= 350,000+ 200,000 = $550,000

EPS= 2460,000/ 550,000

=$4.47

b)

PART 3: I will choose Plan A of selling bonds since it gives a higher return to equity holders.

c)

PART 4: DFL for the Alternative 1 (Bonds)

DFL= EBIT/ (EBIT-Interest)

= 4300,000/ 3500,000

= 1.23

PART 5

DFL For alternative 2:

=4300,000/ 4100,000

=1.05