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soniashah71
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Posted: 13 Jul 2011 at 10:34 \| IP Logged

I have no idea how they get the answer...Please help

Q: A company currently has 1,000 shares of common stock outstanding with zero debt. It has the choice of raising an additional $100,000 by issuing 9% long-term debt or issuing 500 shares of common stock. The company has a 40% tax rate. What level of earnings before interest and taxes (EBIT) would result in the same earnings per share (EPS) for the two financing options

Answer: An EBIT of $27,000 would result in EPS of $10.80 for both.

EPS is equal to $10.80 whether 500 shares of additional stock or $100,000 of 9% long-term debt is issued. If the debt were issued, net income would be equal to $10,800, and the average number of shares would be 1,000. Therefore, the EPS would be $10.80 ($10,800 ÷ 1,000). If additional stock were issued, net income would be equal to $16,200 and weighted shares outstanding would be 1,500. Therefore, EPS would also be $10.80 ($16,200 ÷ 1,500).

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studentcpa
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Posted: 13 Jul 2011 at 10:53 \| IP Logged

EPS= Earnings after interest and tax/No. of Common Stock
shares. Questions says the two options result in same
EPS. So, we equate the formula for the 2 options. Assume
EBIT is "x".

Option 1= Raising Debt. Interest on debt should be
considered.i.e. 9% on $100,000= $9000. Applying the EPS
formula, (x-9000)*0.6 (post tax income)/1000 common stock
shares.

Option 2= Raising equity. EPS= x*0.6/1500 shares.

Now, equate the two options and solve for x, then use
this in either of the formulas to get EPS.

Hope this helps

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soniashah71
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Posted: 13 Jul 2011 at 16:00 \| IP Logged

I am unfortunatly still confused.

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GleimCPA
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Posted: 06 Feb 2012 at 21:08 \| IP Logged

EPS equals net income divided by shares of common stock. When the company issues debt, the EPS equals [(1 - tax rate) * (EBIT - interest)] / outstanding shares. When the company issues new stock, there will be no interest to subtract, [EBIT * (1 - tax rate)] / outstanding shares.

We can set these two equations equal to each other:

[(1 - .4) * (EBIT - $9,000)] / 1,000 = [EBIT * (1 - .4)] / 1,500
(.6 * EBIT - .6 * $9,000) / 1,000 = (.6 * EBIT) / 1,500
Multiply both sides by 1,500:
1.5 * (.6EBIT - $5,400) = .6EBIT
.9EBIT - $8,100 = .6EBIT
.3EBIT = $8,100
EBIT = $27,000

We can now plug $27,000 into either of the EPS formulas:
Stock: ($27,000 * .6) / 1,500 = $10.80
Debt: [.6 * ($27,000 - $9,000)] / 1,000 = $10.80

Please let me know if you have further questions!

jl0329
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Posted: 10 Feb 2012 at 13:58 \| IP Logged

The easiest way is to just plug the 27000 from the MC
answer into the equations and see if they equates.

EPS = (EBIT - int.exp - tax )/ # of CS

and then solve for the EPS.

The above posters already gave you very clear explanation
of the equations.

The main thing they are testing here is the difference
between Debt & equity financing.

With debt, you need to consider interest expense net of
tax.

With equity, you need to consider the additional # of CS.

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