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Financial Leverage and EBIT-EPS Analysis

1. Geoff's Golf Clubs is considering purchasing a small firm in the same line of business. 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 will affect the earnings potential of the firm. Total financing required is $4.5 million. The firm currently has $20,000,000 of 12 percent bonds and 600,000 common shares outstanding. The firm can arrange financing of the $4.5 million through a 14 percent bond issue or the sale of 100,000 shares of common stock. The firm has a 40 percent tax rate.

(a) What is the degree of financial leverage for each plan at $7,000,000 of EBIT?

(b) What is the financial breakeven point for each plan?

2. Kiarra Doll Factory is considering two capital structures. Assume a 40 percent tax rate and expected EBIT of $50,000.

Source of Capital Structure 1 Structure 2
Long-term debt $500,000 @ 8% $350,000 @ 7%
Common Stock 10,000 shares 20,000 shares

(a) Calculate two EBIT-EPS coordinates for each of the structures, using $50,000 as one of your choices.

(b) Plot the two capital structures on a set of EBIT-EPS axes.

(c) Indicate over what EBIT range, if any, each structure is preferred.

(d) Discuss the leverage and risk aspects of each structure.

3. IDWV Bicycle Manufacturing has total assets of $20,000,000. Further, its EBIT is $2,000,000 and it pays preferred dividends of $250,000. It is taxed in the 40% tax bracket. In an effort to determine the optimal capital structure, the firm as assembled data on the cost of debt, the number of shares of common stock for various levels of indebtedness, and the overall required return on investment:

Capital structure debt ratio Cost of debt kd # of Common Shares Required return, ks
0% 0% 500,000 6%
15% 4% 425,000 7%
25% 6% 375,000 8%
50% 8% 250,000 12%
75% 12% 125,000 16%

(a) Calculate the earnings per share (EPS) for each level of indebtedness.

(b) Use equation 12.12 and the EPS calculated in (a) to calculate a price per share for each level of indebtedness.

(c) Choose the optimal capital structure and justify your choice.

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Solution Summary

The solution explains how to do EBIT-EPS analysis and provides answers and calculations for each of the questions. Answers are provided in an attached Word file.