5-11. Continued a. Compute earnings per share if earnings before interest and taxes are $20,000 $30,000, and $120,000(assume a 30 percent tax rate b. Explain the relationship between earnings per share and the level of EBIT c. If the cost of debt went up to 12 percent and all other factors remained equal what would be the break-even level for ebit? Solution: Leno drug stores and hall pharmaceuticals eno Hall EBIT 20.000 $20,000 Less: Interest 10000 20000 EBT 10000 Less: Taxes 30% 3000 EAT 7.000 000 Shares 20000 10.000 EPS $.35 0 EBIT $30000 $30.000 Less Interest 0.000 20.000 EBT 20.000 10.000 Less: Taxes 30% 6.000 3.000 EAT 14.000 7.000 Shares 20.000 10.000 EPS $.70 $.70 EBIT $120,000 $120000 Less Interest 10000 20000 EBT 110.000 100000 Less: Taxes@ 30% 33.000 30.000 EAT 77.000 70000 Shares 20.000 10.000 EPS $3.85 700 Copyright o2005 by The McGranr-Hill Companies, Inc. S-174
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-174 5-11. Continued a. Compute earnings per share if earnings before interest and taxes are $20,000, $30,000, and $120,000 (assume a 30 percent tax rate). b. Explain the relationship between earnings per share and the level of EBIT. c. If the cost of debt went up to 12 percent and all other factors remained equal, what would be the break-even level for EBIT? Solution: Leno Drug Stores and Hall Pharmaceuticals a. Leno Hall EBIT $ 20,000 $ 20,000 Less: Interest 10,000 20,000 EBT 10,000 0 Less: Taxes @ 30% 3,000 0 EAT 7,000 0 Shares 20,000 10,000 EPS $.35 0 EBIT $ 30,000 $ 30,000 Less: Interest 10,000 20,000 EBT 20,000 10,000 Less: Taxes @ 30% 6,000 3,000 EAT 14,000 7,000 Shares 20,000 10,000 EPS $.70 $.70 EBIT $120,000 $120,000 Less: Interest 10000 20,000 EBT 110,000 100,000 Less: Taxes @ 30% 33,000 30,000 EAT 77,000 70,000 Shares 20,000 10,000 EPS $3.85 $7.00
5-11. Continued b. Before-tax return on assets=6.67%0, 10% and 40% at the respective levels of EBIT. When the before-tax return on assets (EBit/ Total Assets)is less than the cost of debt (10%), Leno does better with less debt than hall. when before-tax return on assets is equal to the cost of debt, both firms have equal EPS. This would be where the method of financing has a neutral effect on ePs. as return on assets becomes greater than the interest rate financial leverage becomes more favorable for hall c. 12%x$.000=$36000 break-even level for EBIt In Problem 11, compute the stock price for Hall Pharmaceuticals if it sells at 13 times earnings per share and EBIT is $80,000 Solution: Hall Pharmaceuticals( Continued) EBIT $80.000 Less Interest 20.000 EBT $60000 Less:Taxes@30% 18000 EAT $42.000 Shares 10,000 EPS 4.20 P/E 13x Stock price $5460 S-175 Copyright o by The McGraw-Hill Companies. In
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-175 5-11. Continued b. Before-tax return on assets = 6.67%, 10% and 40% at the respective levels of EBIT. When the before-tax return on assets (EBIT/Total Assets) is less than the cost of debt (10%), Leno does better with less debt than Hall. When before-tax return on assets is equal to the cost of debt, both firms have equal EPS. This would be where the method of financing has a neutral effect on EPS. As return on assets becomes greater than the interest rate, financial leverage becomes more favorable for Hall. c. 12% x $300,000 = $36,000 break-even level for EBIT. 5-12. In Problem 11, compute the stock price for Hall Pharmaceuticals if it sells at 13 times earnings per share and EBIT is $80,000. Solution: Hall Pharmaceuticals (Continued) EBIT $80,000 Less: Interest 20,000 EBT $60,000 Less: Taxes @ 30% 18,000 EAT $42,000 Shares 10,000 EPS $ 4.20 P/E 13x Stock Price $ 54.60
Pulp paper Company and Holt Paper Company are able to generate earnings before interest and taxes of$150,000 The separate capital structures for Pulp and Holt are shown below Holt Debt@ 10% $800,000Debt@10 $400000 Common stock, $5 pa 700.000 Common stock, $5 par. 1.100.000 $1,500,000 Total $1,500,00 Common shares 140.000 Common shares a. Compute earnings per share for both firms. Assume a 40 percent tax rate b. In part a, you should have gotten the same answer for both companies earnings per share. Assume a P/e ratio of 20 for each company, what would c. Now as part of your analysis, assume the p/E ratio would be 15 for the skier company in terms of heavy debt utilization in the capital structure and 26 for the less risky company. What would the stock prices for the two firms be under these assumptions?(Note: Although interest rates also would likely be different based on risk, we hold them constant for ease of analysis) d. Based on the evidence in part c, should management only be concerned about the impact of financing plans on earnings per share or should stockholders' wealth maximization(stock price) be considered as well? Copyright o2005 by The McGranr-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-176 5-13. Pulp Paper Company and Holt Paper Company are able to generate earnings before interest and taxes of $150,000. The separate capital structures for Pulp and Holt are shown below: Pulp Holt Debt @ 10%.................... $ 800,000 Debt @ 10%.................. $ 400,000 Common stock, $5 par..... 700,000 Common stock, $5 par .. 1,100,000 Total............................... $1,500,000 Total ............................ $1,500,000 Common shares............... 140,000 Common shares............. 220,000 a. Compute earnings per share for both firms. Assume a 40 percent tax rate. b. In part a, you should have gotten the same answer for both companies' earnings per share. Assume a P/E ratio of 20 for each company, what would its stock price be? c. Now as part of your analysis, assume the P/E ratio would be 15 for the riskier company in terms of heavy debt utilization in the capital structure and 26 for the less risky company. What would the stock prices for the two firms be under these assumptions? (Note: Although interest rates also would likely be different based on risk, we hold them constant for ease of analysis). d. Based on the evidence in part c, should management only be concerned about the impact of financing plans on earnings per share or should stockholders' wealth maximization (stock price) be considered as well?