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A Discussion On EBIT-EPS Calculations

Moon and Chittenden are considering a new Internet venture to sell used textbooks. The project requires $300,000 in financing. Two alternatives have been proposed.

Plan 1 (Common equity financing). Sell 30, 000 shares of stock at a net price of $10 per share.

Plan 2 (Debt equity financing). Sell a combination of 15,000 shares of stock at a net price of $10 per share and $150,000 of long-term debt at a pretax interest rate of 12 percent.

Assume the corporate tax rate is 40 percent.

a. Compute the indifference level of EBIT between these two alternatives

b. If the firm's EBIT next year has an expected value of $25,000, which plan would you recommend assuming maximizing EPS is a valid objective?

Solution Preview

Moon and Chittenden are considering a new Internet venture to sell used textbooks. The project requires $300,000 in financing. Two alternatives have been proposed.

Plan 1 (Common equity financing). Sell 30, 000 shares of stock at a net price of $10 per share.

Plan 2 (Debt equity financing). Sell a combination of 15,000 shares of stock at a net price of $10 per share and $150,000 of long-term debt at a pretax interest rate of 12 percent.

Assume the corporate tax rate is 40 percent.

a. Compute the indifference level of EBIT between these two alternatives

Plan A
Debt= $0
Equity= $300,000
# of shares= 30,000
Interest rate= 12.00%
Interest expense= $0.00

Plan B
Debt= $150,000
Equity= $150,000
# of shares= 15,000
Interest ...

Solution Summary

The solution calculates EPS for different financing methods-Common equity financing, Debt equity financing.

$2.19