Problem 1. EBIT and Leverage.
Big Apple, Inc., has no debt outstanding and a total market value of $80,000. Earnings before interest and taxes, EBIT, are projected to be $10,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 20 percent higher. If there is a recession, then EBIT will be 30 percent lower. Big Apple is considering a $40,000 debt issue with a 5 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 4,000 shares outstanding. Ignore taxes for this problem.
a. Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is issued. Also, calculate the percentage changes in EPS when the economy expands or enters a recession.
b. Repeat part (a) assuming that Big Apple goes through with recapitalization.
What do you observe?
Problem 2. EBIT, Taxes, and Leverage.
Repeat parts (a) and (b) in Problem 1 assuming Big Apple has a tax rate of 35 percent.
Problem 3. Break-Even EBIT.
Duval Corporation is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, Duval would have 600,000 shares of stock outstanding. Under Plan II, there would be 300,000 shares of stock outstanding and $10 million in debt outstanding. The interest rate on the debt is 10 percent, and there are no taxes.
a. If EBIT is $1.5 million, which plan will result in the higher EPS?
b. If EBIT is $11 million, which plan will result in the higher EPS?
c. What is the break-even EBIT?