Chapter 14, Problem 20P

a.

Summary Introduction

To compute: Indifference points of EBIT and EPS.

Explanation of Solution

Given information:

Tax rate: 40%

Average EBIT level: $6 million (per year)

Calculating EBIT-EPS indifference point:

Indifference can be seen, when debt financing EPS is considered equals to equity financing EPS,

Now,

$\begin{array}{l}\text{ EPS }\left(\text{Plan 1}\right)\text{ = EPS }\left(\text{Plan 2}\right)\\ \frac{\left(\text{EBIT}-\text{ Interest}\right)\left(\text{1}-\text{Tax}\right)}{\text{Outstanding shares}}\text{=}\frac{\left(\text{EBIT}-\text{ Interest}\right)\left(\text{1}-\text{Tax}\right)}{\text{Outstanding shares}}\\ \frac{\left(\text{EBIT}-0\right)\left(1-.4\right)}{2}\text{ = }\frac{\left(\text{EBIT}-1.2\right)\left(1-.4\right)}{1}\\ \text{ EBIT = \$2}\text{.4million}\end{array}$

Therefore, the indifference point will be seen when EBIT become $2.4million

b.

Summary Introduction

To compute: Earning per share for financial plan 1 and plan 2.

Explanation of Solution

Calculating EPS for both financial plans:

	Plan 1 ($)	Plan 2 ($)
EBIT	6.0	6.0
Interest	0.0	1.2
Earning before tax	6.0	4.8
Tax@40%	2.4	1.92
Earnings after tax	3.6	2.88
Outstanding shares	2.0	1.0
EPS	1.80	2.88

Table (1)

Therefore, the earning per share for Plan 1 will be $1.80 and Plan 2 will be $2.88

c.

Summary Introduction

To determine: Factors for financial planning.

Explanation of Solution

The factors for financial planning are as mentioned below:

• Capital structure, which is effectively followed by the parent company.
• Impact of financial plan on the financial status as well as stocks prices of the company.
• Probability distribution as per the expectation identified through EBIT.

d.

Summary Introduction

To determine: Suitable financial plan.

Explanation of Solution

The plan 2 is must be recommended, because EPS (debt financing) is higher the EPS (equity financing).

e.

Summary Introduction

To compute: Earning per share when sales decreases by 5%.

Explanation of Solution

$\begin{array}{l}\text{Time Interest Earned Ratio = }\frac{\text{EBIT}}{\text{Interest}}\\ \text{ = }\frac{\text{6}\text{.0}}{1.2}\\ \text{ = 5 Times}\end{array}$

Therefore, the time interest earned ratio will be 5 times.

f.

Summary Introduction

To compute: EBIT dropping level.

Explanation of Solution

$\begin{array}{l}\text{Level of EBIT = Interest}\times \text{ Time interest earned ratio}\\ \text{ = }\left(1.2\right)(3.5)\\ \text{ = \$4}\text{.2 million}\end{array}$

Therefore, the EBIT is supposed be drop by $1.8 (after deducting current EBIT from lower level). Along with that, it is required for the company to compliance with the agreement of loan.

g.

Summary Introduction

To compute: Probability of negative EPS.

Explanation of Solution

Calculating earnings per share negative probability:

$\begin{array}{l}\text{Z score = }\frac{\text{Loss level}-\text{Expected EBIT}}{\text{Standard deviation}}\\ =\frac{\text{\$0}-\$600,000}{\$300,000}\\ \text{ = }-2.0\end{array}$

From Table V, the probability of a value greater than 2.0 standard deviations to the left of the mean is 2.28%, i.e. small.

Therefore, the probability of negative earning per share will be 2.28%.