Question

Edsel Research Labs has \(27 million in assets. Currently half of these assets are financed with long-term debt at 5 percent and half with common stock having an apar value of \)10. Ms. Edsel, the vice president of finance, wishes to analyze two refinancing plans, one with more debt (D) and one with more equity (E). The company earns a return on assets before interest and taxes of 5 percent. The tax rate is 30 percent.

Under Plan D, a \(6.75 million long-term bond would be sold at an interest

rate of 11 percent and 675,000 shares of stock would be purchased in the market

at \)10 per share and retired. Under Plan E, 675,000 shares of stock would be

sold at \(10 per share and the \)6,750,000 in proceeds would be used to reduce

long-term debt.

a. How would each of these plans affect earnings per share? Consider the current

plan and the two new plans. Which plan(s) would produce the highest EPS?

Short answer

EPS of Plan E and current plan is equal and highest i.e. 0.35. It is so because the interest cost under plan D is more than the current plan and Plan E.

Step-by-step solution

Number of shares under the current plan

Total Assets	$27,000,000
Equity = 50% of total assets	$13,500,000 ($27,000,000 x 50%)
No. of shares (Equity/Par value)	1,350,000 ($13,500,000/$10)

Number of shares under plan D

Total Assets	$27,000,000
Equity = 50% of total assets	$13,500,000 ($27,000,000 x 50%)
Less: Repurchase of shares	$6,750,000
Balance equity	$6,750,000
No. of shares (Equity/Par value)	675,000 ($6,750,000/$10)

Number of shares under plan E

Total Assets	$27,000,000
Equity = 50% of total assets	$13,500,000 ($27,000,000 x 50%)
Add: Additional equity issued	$6,750,000
Balance equity	$20,250,000
No. of shares (Equity/Par value)	2,025,000 ($20,250,000/$10)

EBIT

$\begin{array}{rcl}\mathbf{EBIT}& \mathbf{=}& \mathbf{Totalassets}\mathbf{\times }\mathbf{Returnonassets}\\ & \mathbf{=}& \mathbf{\$}\mathbf{27}\mathbf{million}\mathbf{\times }\mathbf{5}\mathbf{\%}\\ & \mathbf{=}& \mathbf{\$}\mathbf{1}\mathbf{.}\mathbf{35}\mathbf{million}\end{array}$

Interest expense under current plan

$\begin{array}{rcl}\mathbf{Interest}& \mathbf{=}& \mathbf{Longtermdebt}\mathbf{\times }\mathbf{Interestrate}\\ & \mathbf{=}& \mathbf{\$}\mathbf{13}\mathbf{.}\mathbf{5}\mathbf{million}\mathbf{\times }\mathbf{5}\mathbf{\%}\\ & \mathbf{=}& \mathbf{\$}\mathbf{675}\mathbf{,}\mathbf{000}\end{array}$

Interest expense under plan D

$\begin{array}{rcl}\mathbf{Interest}& \mathbf{=}& \left(\mathbf{ExistingLongtermdebt}\mathbf{\times }\mathbf{Interestrate}\right)\mathbf{+}\left(\mathbf{Newlongtermbondissue}\mathbf{\times }\mathbf{Interestrate}\right)\\ & \mathbf{=}& \left(\mathbf{\$}\mathbf{13}\mathbf{,}\mathbf{500}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{5}\mathbf{\%}\right)\mathbf{+}\left(\mathbf{\$}\mathbf{6}\mathbf{,}\mathbf{750}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{11}\mathbf{\%}\right)\\ & \mathbf{=}& \mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{417}\mathbf{,}\mathbf{500}\end{array}$

Interest expense under plan E

$\begin{array}{rcl}\mathbf{Interest}& \mathbf{=}& \left(\left(\mathbf{ExistingLongtermdebt}\mathbf{-}\mathbf{Redeemeddebt}\right)\mathbf{\times }\mathbf{Interestrate}\right)\\ & \mathbf{=}& \left(\left(\mathbf{\$}\mathbf{13}\mathbf{,}\mathbf{500}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{6}\mathbf{,}\mathbf{750}\mathbf{,}\mathbf{000}\right)\mathbf{\times }\mathbf{5}\mathbf{\%}\right)\\ & \mathbf{=}& \mathbf{\$}\mathbf{337}\mathbf{,}\mathbf{500}\end{array}$

Comparison by computing EPS

Particulars	Current Plan	Plan D	Plan E
EBIT	1,350,000	1,350,000	1,350,000
Less: Interest	675,000	1,417,500	337,500
EBT	675,000	(67,500)	1,012,500
Less: Tax @30%	202,500	(20,250)	303,750
Net Income (A)	472,500	(47,250)	708,750
No. of shares (B)	1,350,000	675,000	2,025,000
EPS (A/B)	0.35	(0.07)	0.35

The highest EPS is produced by Plan E and current plan, because they both have same EPS. It is so because of the interest cost.