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.

b. Which plan would be most favorable if return on assets fell to 5 percent? Increased to 15 percent? Consider the current plan and the two new plans.

Step by step solution

01

EBIT when return on asset is 5%

$$\begin{gathered} \mathbf{EBIT}\mathbf{=}\mathbf{Totalassets}\mathbf{\times }\mathbf{Returnonassets} \\ \mathbf{=}\mathbf{\$}\mathbf{12}\mathbf{million}\mathbf{\times }\mathbf{5}\mathbf{\%} \\ \mathbf{=}\mathbf{\$}\mathbf{600}\mathbf{,}\mathbf{000} \end{gathered}$$

02

EPS when return on asset is 5%

Particulars	Current Plan	Plan D	Plan E
EBIT	600,000	600,000	600,000
Less: Interest	600,000	960,000	300,000
EBT	0	(360,000)	300,000
Less: Tax @45%	0	(162,000)	135,000
Net Income (A)	0	(198,000)	165,000
No. of shares (B)	750,000	375,000	1,125,000
EPS (A/B)	0	(0.53)	0.15

03

EBIT when return on asset is 15%

$$\begin{gathered} \mathbf{EBIT}\mathbf{=}\mathbf{Totalassets}\mathbf{\times }\mathbf{Returnonassets} \\ \mathbf{=}\mathbf{\$}\mathbf{12}\mathbf{million}\mathbf{\times }\mathbf{15}\mathbf{\%} \\ \mathbf{=}\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{800}\mathbf{,}\mathbf{000} \end{gathered}$$

04

EPS when return on asset is 15%

Particulars	Current Plan	Plan D	Plan E
EBIT	1,800,000	1,800,000	1,800,000
Less: Interest	600,000	960,000	300,000
EBT	1,200,000	840,000	1,500,000
Less: Tax @45%	540,000	378,000	675,000
Net Income (A)	660,000	462,000	825,000
No. of shares (B)	750,000	375,000	1,125,000
EPS (A/B)	0.88	1.23	0.73

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