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.

c. Assuming return on assets is back to the original 5 percent, but the interest

rate on new debt in Plan D is 7 percent, which of the three plans will produce

the highest EPS? Why?

Step by step solution

01

Interest expense under current plan

$$\begin{gathered} \mathbf{Interest}\mathbf{=}\mathbf{Longtermdebt}\mathbf{\times }\mathbf{Interestrate} \\ \mathbf{=}\mathbf{\$}\mathbf{13}\mathbf{.}\mathbf{5}\mathbf{million}\mathbf{\times }\mathbf{5}\mathbf{\%} \\ \mathbf{=}\mathbf{\$}\mathbf{675}\mathbf{,}\mathbf{000} \end{gathered}$$

02

Interest expense under plan D

$$\begin{gathered} \mathbf{Interest}\mathbf{=}\left(\mathbf{ExistingLongtermdebt}\mathbf{\times }\mathbf{Interestrate}\right)\mathbf{+}\left(\mathbf{Newlongtermbondissue}\mathbf{\times }\mathbf{Interestrate}\right) \\ \mathbf{=}\left(\mathbf{\$}\mathbf{13}\mathbf{,}\mathbf{500}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{5}\mathbf{\%}\right)\mathbf{+}\left(\mathbf{\$}\mathbf{6}\mathbf{,}\mathbf{750}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{7}\mathbf{\%}\right) \\ \mathbf{=}\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{147}\mathbf{,}\mathbf{500} \end{gathered}$$

03

Interest expense under plan E

$$\begin{gathered} \mathbf{Interest}\mathbf{=}\left(\left(\mathbf{ExistingLongtermdebt}\mathbf{-}\mathbf{Redeemeddebt}\right)\mathbf{\times }\mathbf{Interestrate}\right) \\ \mathbf{=}\left(\left(\mathbf{\$}\mathbf{13}\mathbf{,}\mathbf{500}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{6}\mathbf{,}\mathbf{750}\mathbf{,}\mathbf{000}\right)\mathbf{\times }\mathbf{5}\mathbf{\%}\right) \\ \mathbf{=}\mathbf{\$}\mathbf{337}\mathbf{,}\mathbf{500} \end{gathered}$$

04

Calculating EPS under the three plan

Particulars	Current Plan	Plan D	Plan E
EBIT	1,350,000	1,350,000	1,350,000
Less: Interest	675,000	1,147,500	337,500
EBT	675,000	202,500	1,012,500
Less: Tax @30%	202,500	60,750	303,750
Net Income (A)	472,500	141,750	708,750
No. of shares (B)	1,350,000	675,000	2,025,000
EPS (A/B)	0.35	0.21	0.35

Current plan and plan E produce highest EPS due to low interest cost.

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