Question

Problem 5-24 Leverage and sensitivity analysis (LO5-6] Edsel Research Labs has $29.40 million in assets. Currently half of these assets are financed with long-term debt at 5 percent and half with common stock having a par value of $10. Ms. Edsel, the 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 5 percent. The tax rate is 30 percent. Under Plan D, a $7.35 million long-term bond would be sold at an interest rate of 11 percent and 735,000 shares of stock would be purchased in the market at $10 per share and retired. Under Plan E, 735,000 shares of stock would be sold at $10 per share and the $7,350,000 in proceeds would be used to reduce long-term debt. a-1. How would each of these plans affect earnings per share? Consider the current plan and the two new plans. (Round your answers to 2 decimal places.) Earnings per Share Current Plan D Plan E a-2. Which plan(s) would produce the highest EPS? Note that due to tax loss carry-forwards and carry-backs, taxes can be a negative number. O The Current Plan and Plan E O Plan D O Plan E O Current Plan

Answer 1

a -1

	Earnings per share
Current	0.46
Plan D	0.29
Plan E	0.46

Workings

Note. In Plan D and Plan E fresh shares issued are assumed as common stock ( Equity) shares.

	Computaion of EPS	Current	Plan D	Plan E
	Earnings before Interest & taxes ( GIVEN 5 % return on assets)	1470000	1470000	1470000
Less	Interest	735000	808500	367500
	Earnings before taxes	735000	661500	1102500
Less	Tax @ 5%	36750	33075	55125
	Net profit	698250	628425	1047375
	EPS = Net profit/Number of common stock shares
	Number of shares	1470000	2205000	2205000
	EPS	0.475	0.285	0.475
	EPS ( Rounded to two decimals )	0.46	0.29	0.46

Combinations of Finances		In millon			In millon			In millon
Current			Plan D			Plan E
Common stock @ 10/share	14700000	14.7	Common stock @ 10/share	14700000	14.7	Common stock @ 10/share	14700000	14.7
Long term debt @ 5%	14700000	14.7	Long term bond @ 11%	7350000	7.35	New shares( common atock)	7350000	7.35
			New shares( common atock)	7350000	7.35	Long ter debt @ 5% ( 14700000 - Proceedigs from issue of shares 735000 0	7350000	7.35
Total	29400000	29.4		29400000	29.4		29400000	29.4
Retun on assets ( 29.4 X 5%)	1470000	1.47	Retun on assets ( 29.4 X 5%)	1470000	1.47	Retun on assets ( 29.4 X 5%)	1470000	1.47
Interset expenses	735000	0.735	Interset expenses	808500	0.8085	Interset expenses	367500	0.3675
( 14700000 x 5%)			( 7350000 X 11% )			( 7350000 X 5 % )
Number of common stock shrares	1470000		Number of common stock shrares	2205000		Number of common stock shrares	2205000

a - 2

The current plan and plan E would produce higest EPS (0.46 ) compared to plan D ( 0.29 )

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