Dickinson Company has \(12 million in assets. Currently half of these assets are financed with long-term debt at 10 percent and half with common stock having a par value of \)8. Ms. Smith, 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 10 percent. The tax rate is 45 percent.

Under Plan D, a \(3 million long-term bond would be sold at an interest rate

of 12 percent and 375,000 shares of stock would be purchased in the market at

\)8 per share and retired.

Under Plan E, 375,000 shares of stock would be sold at \(8 per share and the

\)3,000,000 in proceeds would be used to reduce long-term debt.

a. How would each of these plans affect earnings per share? Consider the current

plan and the two new plans.

Step by step solution

01

Number of shares under the current plan

Total Assets	$12,000,000
Equity = 50% of total assets	$6,000,000 ($12,000,000 x 50%)
No. of shares (Equity/Par value)	750,000 ($6,000,000/$8)

02

Number of shares under plan D

Total Assets	$12,000,000
Equity = 50% of total assets	$6,000,000 ($12,000,000 x 50%)
Less: Repurchase of shares	$3,000,000
Balance equity	$3,000,000
No. of shares (Equity/Par value)	375,000 ($3,000,000/$8)

03

Number of shares under plan E

Total Assets	$12,000,000
Equity = 50% of total assets	$6,000,000 ($12,000,000 x 50%)
Add: Additional equity issued	$3,000,000
Balance equity	$9,000,000
No. of shares (Equity/Par value)	1,125,000 ($9,000,000/$8)

04

EBIT

$$\begin{gathered} \mathbf{EBIT}\mathbf{=}\mathbf{Totalassets}\mathbf{\times }\mathbf{Returnonassets} \\ \mathbf{=}\mathbf{\$}\mathbf{12}\mathbf{million}\mathbf{\times }\mathbf{10}\mathbf{\%} \\ \mathbf{=}\mathbf{\$}\mathbf{1}\mathbf{.}\mathbf{2}\mathbf{million} \end{gathered}$$

05

Interest expense under current plan

$$\begin{gathered} \mathbf{Interest}\mathbf{=}\mathbf{Longtermdebt}\mathbf{\times }\mathbf{Interestrate} \\ \mathbf{=}\mathbf{\$}\mathbf{6}\mathbf{million}\mathbf{\times }\mathbf{10}\mathbf{\%} \\ \mathbf{=}\mathbf{\$}\mathbf{600}\mathbf{,}\mathbf{000} \end{gathered}$$

06

Interest expense under plan D

$$\begin{gathered} \mathbf{Interest}\mathbf{=}\left(\mathbf{ExistingLongtermdebt}\mathbf{\times }\mathbf{Interestrate}\right)\mathbf{+}\left(\mathbf{Newlongtermbondissue}\mathbf{\times }\mathbf{Interestrate}\right) \\ \mathbf{=}\left(\mathbf{\$}\mathbf{6}\mathbf{million}\mathbf{\times }\mathbf{10}\mathbf{\%}\right)\mathbf{+}\left(\mathbf{\$}\mathbf{3}\mathbf{,}\mathbf{000}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{12}\mathbf{\%}\right) \\ \mathbf{=}\mathbf{\$}\mathbf{960}\mathbf{,}\mathbf{000} \end{gathered}$$

07

Interest expense under plan E

$$\begin{gathered} \mathbf{Interest}\mathbf{=}\left(\left(\mathbf{ExistingLongtermdebt}\mathbf{-}\mathbf{Redeemeddebt}\right)\mathbf{\times }\mathbf{Interestrate}\right) \\ \mathbf{=}\left(\left(\mathbf{\$}\mathbf{6}\mathbf{million}\mathbf{-}\mathbf{\$}\mathbf{3}\mathbf{million}\right)\mathbf{\times }\mathbf{10}\mathbf{\%}\right) \\ \mathbf{=}\mathbf{\$}\mathbf{300}\mathbf{,}\mathbf{000} \end{gathered}$$

08

Calculation of EPS

Particulars	Current Plan	Plan D	Plan E
EBIT	1,200,000	1,200,000	1,200,000
Less: Interest	600,000	960,000	300,000
EBT	600,000	240,000	900,000
Less: Tax @45%	270,000	108,000	405,000
Net Income (A)	330,000	132,000	495,000
No. of shares (B)	750,000	375,000	1,125,000
EPS (A/B)	0.44	0.35	0.44

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