Question

6. EBIT-EPS analysis - Part II Aa Aa Mother Earth Inc. (MEI) was started three years ago by two friends who recently graduated from Blue Rock College. MEI, a multimillion-dollar distributor of environmentally friendly products, currently sells products made by other manufacturers. The management team is now considering the purchase of the manufacturer of MEI's bestselling product. The acquisition is expected to cost $6,000,000, but MEI's chief financial officer (CFO) is unclear as to whether the purchase should be financed using debt or equity funds. MEI's current capital structure consists of 1,000,000 shares of common stock and a $4 million term loan. The interest rate on the loan is 4%, and MEI's tax rate is 40%. The two financing alternatives are: Plan 1 – Common equity financing: Sell an additional 500,000 shares at $12 per share. Plan 2 – Debt financing: Sell $6,000,000 in 6% bonds. MEI's current earnings before interest and taxes (EBIT) is $9,000,000, and is expected to increase to $11,250,000. Given MEI's current situation and acquisition plans, complete the following table: Current earnings per share (EPS) Expected EPS under Plan 1 - Common equity financing Expected EPS under Plan 2 – Debt financing MEI's EBIT-EPS indifference point for the debt and equity financing plans occurs when its EBIT is and its EPS is When the firm's expected EBIT exceeds its EBIT-EPS indifference point and its capital structure contains increasing levels of financing, the firm's EPS will increase. At the same time, the firm's financial risk will Assuming that MEI realizes an EBIT of $6,000,000, all other things being equal, which plan should you rece nmend? O Plan 1 O Plan 2 Either plan O Neither plan

Answer 1

	Current	Plan 1	Plan 2
EBIT	9,000,000	11,250,000	11,250,000
Less: Interest	160,000	160,000	520,000
EBT	8,840,000	11,090,000	10,730,000
Less: Taxes	3,536,000	4,436,000	4,292,000
Net Income	5,304,000	6,654,000	6,438,000
Number of Shares	1,000,000	1,500,000	1,000,000
EPS	5.304	4.436	6.438
Indifference point is the point at which EPS under both the plans is same
Let indifference EBIT be x
(x-160,000)(1-40%)/1,500,000 = (x-520,000)(1-40%)/1,000,000
(0.6x - 96000)*1,000,000 = (0.6x-312000)*1500,000
=-300000*-372000000000
x = $1,240,000
i.e. When EBIT is $1,240,000
and EPS = $0.432
Debt financing
Increase
	Plan 1	Plan 2
EBIT	6,000,000	6,000,000
Less: Interest	160,000	520,000
EBT	5,840,000	5,480,000
Less: Taxes	2,336,000	2,192,000
Net Income	3,504,000	3,288,000
Number of Shares	1,500,000	1,000,000
EPS	2.336	3.288
Plan 2