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Cybernauts, Ltd., is a new firm that wishes to determine an appropriate capital structure.
It can issue 16 percent debt or 15 percent preferred stock. The total capitalization of the
company will be $5 million, and common stock can be sold at $20 per share. The company
is expected to have a 50 percent tax rate (federal plus state). Four possible capital structures
being considered are as follows:
PLAN DEBT PREFERRED EQUITY
1 0% 100%
2 30 7
3 50 50
4 50 30
a, Construct an EBIT-EPS chart for the four plans. (EBIT is expected to be $1 million.)
Be sure to identify the relevant indifference points and determine the horizontal-axis,
intercepts.
b. Using Eg, (16.12), verify the indifference point on your graph between plans | and 3
and between plans 3 and 4
«. Compute the degree of financial leverage (DEL) for each alternative at an expected
EBIT level of $1 million.
. Which plan is best? Why?
Plan
1 3 4
EBIT (in thousands) $1,000 $1,000 $1,000 $1,000
Interest o 240 400 400
EBT $1,000 $760 $ 600 S$ 600
‘Taxes 500 380 300 300
EAT s 500 $ 380 $ 300 $ 300
Preferred dividends o ° ° 150
EACS $ 500 $ 380 $ 300 $ 150
‘Number of shares 250 175 125 5
EPS $ 2.00 $217 $ 240 $2.00 The intercepts on the horizontal axis for the four plans are $0, $240,000, $400,000, and
$700,000 respectively. With this information, the EBIT-EPS indifference chart is:
°
2
PS (n dolars)
° os fl 15
EDIT (n milion of dears) Hi-Grade Regulator Company currently has 100,000 shares of common stock outstanding
with a market price of $60 per share. It also has $2 million in 6 percent bonds. The com-
pany is considering a $3 million expansion program that it can finance with all common,
stock at $60 a share (option 1), straight bonds at 8 percent interest (option 2), preferred
stock at 7 percent (option 3), and half common stock at $60 per share and half 8 percent
bonds (option 4).
a. For an expected EBIT level of $1 million after the expansion program, calculate the
‘earnings per share for each of the alternative methods of financing. Assume a tax rate
of 50 percent.
b. Construct an EBIT-EPS chart. Calculate the indifference points between alternatives.
‘What is your interpretation of them?
Additional-finaneing Plans
1 2) 3 a
Present Half
Capital All all All Common and
stricture. _Common 8% Bonds__Preferred_ Half Bonds
EBIT $1,000 $1,000 $1,000 $1,000 $1,000
Interest 120 120 360 120 240
EBT $880 S 880 $ 640 S880 $ 760
Taxes 440 440 320 440 380
EAT $440 S 440 $ 320 S$ 440 $ 380
Pref, Stk,
Dividend 210
FACS $s 440 s 440 $ 230 $ 380
Shares
outstanding 100 150 100 100 12s
EPS $ 440 $2.93 S 3.20 $ 230 $3.04
