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Break-Even EBIT and Leverage Kolby Corp. is comparing two different capital structures. Plan I would result in 1,500 shares of stock and \(\$ 20,000\) in debt. Plan II would result in 1,100 shares of stock and \(\$ 30,000\) in debt. The interest rate on the debt is 10 percent. 1\. Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be \(\$ 12,000\). The all-equity plan would result in 2,300 shares of stock outstanding. Which of the three plans has the highest EPS? The lowest? 2\. In part (a) what are the break-even levels of EBIT for each plan as compared to that for an all-equity plan? Is one higher than the other? Why? 3\. Ignoring taxes, when will EPS be identical for Plans I and II? 4\. Repeat parts (a), (b), and (c) assuming that the corporate tax rate is \(\mathbf{4 0}\) percent. Are the break-even levels of EBIT different from before? Why or why not?

Step by step solution

01

To calculate the earnings per share (EPS) under each plan, we need to find the earnings available for stockholders. To do this, we need to subtract the interest expense from EBIT. Then, we divide the earnings available for stockholders by the number of shares. The formula for calculating EPS is: \( EPS = \frac{Earnings \, available \, for \, stockholders}{Number \, of \, shares} \) #Step 2: Calculate break-even levels of EBIT#:

To find the break-even levels of EBIT for each plan, we need to investigate when the EPS for Plan I and Plan II is equal to the EPS for the all-equity plan. This can be done by setting the EPS of Plan I and Plan II equal to the EPS of the all-equity plan and solving for EBIT. #Step 3: Find when EPS will be identical for Plans I and II (ignoring taxes)#:

02

To find when the EPS of Plan I and Plan II is the same, we set the EPS equations for both plans equal and solve for EBIT. #Step 4: Repeat steps 1, 2, and 3 considering the corporate tax rate of 40%#:

In this step, we must adjust our calculations for EPS and break-even points considering the corporate tax rate of 40%. The interest expense is now tax-deductible, and the new formula for calculating EPS is: \( EPS = \frac { (1- Tax\, Rate) * Earnings \, available \, for \, stockholders} { Number \, of \, shares } \) Next, we need to repeat the calculations for steps 1, 2, and 3 using this adjusted EPS formula.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Capital Structure Comparison

Capital structure refers to how a firm finances its overall operations and growth through different sources of funds, such as equity, debt, or a mix of both. Comparing various capital structures involves evaluating how different financing mixes impact a company's profitability and risk.

For instance, in the Kolby Corp. scenario, we have three plans: an all-equity plan with no debt and two leveraged plans with varying levels of debt and equity. By comparing the number of shares issued and the debt held under each plan, we can assess how their capital structures influence the break-even EBIT points and the earnings per share (EPS). Students should note that leveraging, which involves borrowing, can amplify both profits and losses, because fixed interest expenses must be paid before distributing earnings to shareholders.

Earnings Per Share (EPS) Calculation

Earnings Per Share (EPS) is a key metric that shows the profitability of a company on a per-share basis. It's commonly used by investors to gauge a company's financial health. To calculate EPS, we subtract any interest payments from EBIT (Earnings Before Interest and Taxes) to find the earnings available to shareholders. Then, we divide this by the number of outstanding shares.

For example, under Kolby Corp.’s Plan I, with an EBIT of \( \(12,000 \), the interest expense (10% of \( \)20,000 \)) is \( \(2,000 \) and the earnings available to the 1,500 shareholders are \( \)10,000 \). Thus, the EPS is \( \frac{10,000}{1,500} \) or \( $6.67 \) per share. Calculating the EPS for each plan allows students to see how leverage increases potential returns to equity holders, thus affecting the decision-making process in corporate finance.

Leverage and Taxes Effect

Leverage involves using borrowed funds to increase the potential return on investment. While leverage can enhance earnings when a company performs well, it also raises the risk factor, especially if the company fails to cover its interest obligations.

Furthermore, taxes have a significant effect on leveraged capital structures because interest payments are tax-deductible, reducing the firm's taxable income. In the context of the Kolby Corp. exercise, incorporating a 40% tax rate changes our EPS calculations because only the after-tax earnings are available to shareholders. Students should understand that the tax shield provided by debt can be favorable, as it lowers the effective cost of debt and increases the after-tax EPS, ceteris paribus (all other factors being constant).

Corporate Finance Education

Corporate finance education arms students with the necessary tools and understanding to make informed financial decisions within a company. Topics like capital structure decisions, EPS calculations, and the effects of leverage and taxes form the bedrock of corporate financial analysis.

Working through exercises such as the one provided by Kolby Corp. helps students appreciate the complexities involved in real-world financial decisions. It highlights the balance between risk and return and the importance of considering tax implications in planning the company's capital structure. By enhancing their comprehension through step-by-step solutions and real-life examples, students can apply these principles effectively in their future finance careers.