Task: EBIT-EPS and Capital Structure
Percy’s, Inc. is considering the purchase of a small company which supplies the firm with a major component used to manufacture its main product.
The purchase would be financed by the sale of common stock or a bond issue.
The financial manager needs to evaluate how the two alternative financing plans would affect the earnings potential of the firm.
Total financing required is $3.0 million. The firm currently has $7,000,000 of 10% bonds and 200,000 shares of common stock outstanding.
The firm can arrange financing of the $3.0 million through either a 12% bond issue or the sale of 50,000 shares of common stock. The firm’s tax rate is 40%.
A) At what EBIT level will EPS = $0 for each financing plan?
B) Graph the two financing plans on a set of EBIT - EPS axes. (Calculate and plot EPS at EBIT levels of $250,000, $500,000, $1,000,000, $1,500,000, $2,500,000, and $3,500,000.)
C) According to your graph, at what EBIT level does the bond financing plan become superior?
D) If the firm estimates EBIT of $3,000,000, which financing plan would you recommend?
You are the CEO of a publicly held company that is considering adopting a dividend policy for the first time in the company's history.
You support the concept of the proposed dividend policy and you are preparing a presentation to the Board of Directors to support your position.
In a paragraph or two, summarize some arguments that you can use to convince the Board that a dividend payout will maximize shareholder wealth.
Consider including in your discussion the concepts of cost of capital, investment opportunities, and the implied relationship between dividend policy and stock price.
Additionally, include in your discussion what target payout ratio you would consider optimal.