Problem 1: 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?
Problem 2: Break-Even EBIT and Leverage.
Hoobastank Co. is comparing two different capital structures. Plan I would result in 1,000 shares of stock and $30,000 in debt. Plan II would result in 2,000 shares of stock and $15,000 in debt. The interest rate on the debt is 10 percent.
a. Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $12,000. The all-equity plan would result in 3,000 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 all-equity plan? Is one higher than the other? Why?
c. Ignoring taxes, when will EPS be identical for Plans I and II?
d. Repeat parts (a), (b), and (c) assuming that the corporate tax rate is 38 percent. Are the break-even levels of EBIT different from before? Why or why not?