Question

The Lopez-Portillo Company has \(10.6 million in assets, 80 percent financed by debt and 20 percent financed by common stock. The interest rate on the debt is 9 percent and the par value of the stock is \)10 per share. President Lopez-Portillo is considering two financing plans for an expansion to \(18 million in assets.

Under Plan A, the debt-to-total-assets ratio will be maintained, but new debt

will cost a whopping 12 percent! Under Plan B, only new common stock at \)10

per share will be issued. The tax rate is 40 percent.

a. If EBIT is 9 percent on total assets, compute earnings per share (EPS) before

the expansion and under the two alternatives.

Short answer

The EPS of the company before expansion under the current plan is $0.54, under plan A is $0.244 and under plan B is $0.54.

Step-by-step solution

Number of shares under the current plan

Total Assets	$10,600,000
Equity = 20% of total assets	$2,120,000 ($10,600,000 x 20%)
No. of shares (Equity/Par value)	212,000 ($2,120,000/$10)

Number of shares under plan A

Total Assets	$18,000,000
Equity = 20% of total assets	$3,600,000 ($18,000,000 x 20%)
No. of shares (Equity/Par value)	360,000 ($3,600,000/$10)

Number of shares under plan B

Total Assets	$18,000,000
Equity (Equity under current plan)	$2,120,000 ($10,600,000 x 20%)
Add: Additional equity issued ($18,000,000-$10,600,000)	$7,400,000
Balance equity	$9,520,000
No. of shares (Equity/Par value)	952,000 ($9,520,000/$10)

EBIT under current plan

$\begin{array}{rcl}\mathbf{EBIT}& \mathbf{=}& \mathbf{Totalassets}\mathbf{\times }\mathbf{Returnonassets}\\ & \mathbf{=}& \mathbf{\$}\mathbf{10}\mathbf{,}\mathbf{600}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{9}\mathbf{\%}\\ & \mathbf{=}& \mathbf{\$}\mathbf{954}\mathbf{,}\mathbf{000}\end{array}$

EBIT under Plan A & B

$\begin{array}{rcl}\mathbf{EBIT}& \mathbf{=}& \mathbf{Totalassets}\mathbf{\times }\mathbf{Returnonassets}\\ & \mathbf{=}& \mathbf{\$}\mathbf{18}\mathbf{,}\mathbf{000}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{9}\mathbf{\%}\\ & \mathbf{=}& \mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{620}\mathbf{,}\mathbf{000}\end{array}$

Interest expense under current plan

$\begin{array}{rcl}\mathbf{Interest}& \mathbf{=}& \mathbf{Longtermdebt}\mathbf{\times }\mathbf{Interestrate}\\ & \mathbf{=}& \left(\mathbf{\$}\mathbf{10}\mathbf{,}\mathbf{600}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{0}\mathbf{.}\mathbf{80}\right)\mathbf{\times }\mathbf{9}\mathbf{\%}\\ & \mathbf{=}& \mathbf{\$}\mathbf{763}\mathbf{,}\mathbf{200}\end{array}$

Interest expense under plan A

$\begin{array}{rcl}\mathbf{Interest}& \mathbf{=}& \left(\mathbf{ExistingLongtermdebt}\mathbf{\times }\mathbf{Interestrate}\right)\mathbf{+}\left(\mathbf{Newlongtermbondissue}\mathbf{\times }\mathbf{Interestrate}\right)\\ & \mathbf{=}& \left(\mathbf{\$}\mathbf{8}\mathbf{,}\mathbf{480}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{9}\mathbf{\%}\right)\mathbf{+}\left(\mathbf{\$}\mathbf{5}\mathbf{,}\mathbf{920}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{12}\mathbf{\%}\right)\\ & \mathbf{=}& \mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{473}\mathbf{,}\mathbf{600}\end{array}$

Interest expense under plan B

$\begin{array}{rcl}\mathbf{Interest}& \mathbf{=}& \mathbf{Longtermdebt}\mathbf{\times }\mathbf{Interestrate}\\ & \mathbf{=}& \left(\mathbf{\$}\mathbf{10}\mathbf{,}\mathbf{600}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{0}\mathbf{.}\mathbf{80}\right)\mathbf{\times }\mathbf{9}\mathbf{\%}\\ & \mathbf{=}& \mathbf{\$}\mathbf{763}\mathbf{,}\mathbf{200}\end{array}$

Calculation of EPS

Particulars	Current Plan	Plan A	Plan B
EBIT	954,000	1,620,000	1,620,000
Less: Interest	763,200	1,473,600	763,200
EBT	190,800	146,400	856,800
Less: Tax @40%	76,320	58,560	342,720
Net Income (A)	114,480	87,840	514,080
No. of shares (B)	212,000	360,000	952,000
EPS (A/B)	0.54	0.244	0.54