Edsel Research Labs has \(27 million in assets. Currently half of these assets are financed with long-term debt at 5 percent and half with common stock having apar value of \)10. Ms. Edsel, the 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 5 percent. The tax rate is 30 percent.

Under Plan D, a \(6.75 million long-term bond would be sold at an interest

rate of 11 percent and 675,000 shares of stock would be purchased in the market

at \)10 per share and retired. Under Plan E, 675,000 shares of stock would be

sold at \(10 per share and the \)6,750,000 in proceeds would be used to reduce

long-term debt.

b. Which plan would be most favorable if return on assets increased to

8 percent? Compare the current plan and the two new plans. What has

caused the plans to give different EPS numbers?

Step by step solution

01

EBIT when return on asset is 8%

$$\begin{gathered} \mathbf{EBIT}\mathbf{=}\mathbf{Totalassets}\mathbf{\times }\mathbf{Returnonassets} \\ \mathbf{=}\mathbf{\$}\mathbf{27}\mathbf{million}\mathbf{\times }\mathbf{8}\mathbf{\%} \\ \mathbf{=}\mathbf{\$}\mathbf{2}\mathbf{,}\mathbf{160}\mathbf{,}\mathbf{000} \end{gathered}$$

02

EPS when return on asset is 8%

Particulars	Current Plan	Plan D	Plan E
EBIT	2,160,000	2,160,000	2,160,000
Less: Interest	675,000	1,417,500	337,500
EBT	1,485,000	742,500	1,822,500
Less: Tax @30%	445,500	222,750	546,750
Net Income (A)	1,039,500	519,750	1,275,750
No. of shares (B)	1,350,000	675,000	2,025,000
EPS (A/B)	0.77	0.77	0.63

03

Comparison between EPS, when the return on asset is 5% and 8%

	EPS when the return on asset is 5%	EPS when the return on asset is 8%
Current plan	0.44	0.77
Plan D	0.35	0.77
Plan E	0.44	0.63

When the return on assets increases to 8%, the current plan and plan D is more favorable than plan E. It is so because of the interest cost incurred by the company.

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