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Dickinson Company has \(12 million in assets. Currently half of these assets are financed with long-term debt at 10 percent and half with common stock having a par value of \)8. Ms. Smith, 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 10 percent. The tax rate is 45 percent.

Under Plan D, a \(3 million long-term bond would be sold at an interest rate

of 12 percent and 375,000 shares of stock would be purchased in the market at

\)8 per share and retired.

Under Plan E, 375,000 shares of stock would be sold at \(8 per share and the

\)3,000,000 in proceeds would be used to reduce long-term debt.

c. If the market price for common stock rose to \(12 before the restructuring, which plan would then be most attractive? Continue to assume that \)3 million in debt will be used to retire stock in Plan D and $3 million of new equity will be sold to retire debt in Plan E. Also assume for calculations in part c that return on assets is 10 percent.

Step by step solution

01

Number of shares under the current plan

Total Assets	$12,000,000
Equity = 50% of total assets	$6,000,000 ($12,000,000 x 50%)
No. of shares (Equity/Par value)	750,000 ($6,000,000/$8)

02

Number of shares under plan D

Total Assets	$12,000,000
Equity = 50% of total assets	$6,000,000 ($12,000,000 x 50%)
Less: Repurchase of shares	$3,000,000
Balance equity	$3,000,000

Original number of shares	750,000 ($6,000,000/$8)
Less: No. of repurchased shares	250,000 (3,000,000/$12)
Revised no. of shares	500,000

03

Number of shares under plan E

Total Assets	$12,000,000
Equity = 50% of total assets	$6,000,000 ($12,000,000 x 50%)
Add: Additional equity issued	$3,000,000
Balance equity	$9,000,000

Original number of shares	750,000 ($6,000,000/$8)
Add: No. of additional shares issued	250,000 (3,000,000/$12)
Revised no. of shares	1,000,000

04

Comparison of the current plan, plan D and plan E by computing EPS

Particulars	Current Plan	Plan D	Plan E
EBIT	1,200,000	1,200,000	1,200,000
Less: Interest	600,000	960,000	300,000
EBT	600,000	240,000	900,000
Less: Tax @45%	270,000	108,000	405,000
Net Income (A)	330,000	132,000	495,000
No. of shares (B)	750,000	500,000	1,000,000
EPS (A/B)	0.44	0.26	0.50

EPS of Plan E is highest and more attractive than the current plan and Plan D

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