2 Finance Questions For Pavan 1000

(EBIT-IPS break-even analysis) Home Depot, Inc. (HD] had l.?0 billion shares of common stock outstanding ir 2008, whereas Lowes Companies, Inc, (LOW) had 1.46 billion shares outstanding. Assuming Home Depofs 2008 interost expense is $695 million, Lowes’interest expense is $239 million, and a 38 percent tax rate for both firms, what is their brcak-even level of operating income (i.e., the level of EBIT where EPS is the same forboth firms)?

STEP l: Picture the Problem

The EBIT’EPS chart (sometimes called the range of eamings chart) is the principal tool used to evaluate the effects of capital stnrcture choices oil eandngs per share. The point of intersection of the two capital stnrcture lines is sometimes called the EBIT-EPS indifference point. This poiut identifies thE EBIT level at which the EPS witl be the same regardless of the financing plan chosen by the firm. This indifference point has major implications for financial planning. At EBIT amounts in excess of the EBIT indilference level, the financing plan with more leverage will gererate a higher EPS. At EBIT amounts below the EBIT indifference level, the financing plan involving less leverage will generate a higher EPS.

STEP 2: Decide on r Solution Strotegy

To find the break-even level of EBIT, we can modiff our inteqpretation of the equation below; instead of considering each side of the equation to represent a financing plan we’re evaluating, we will consider each to be a description of one of our firms:

EP,S for Hgme Depot Inp,

(EBIT- Iglerest Ex.peuserro) x (l – Tax Rate) Shares Outstandingqp

STEP 3: Solve

Shares Outstandiugp

(EBIT* $696,000,09,0) ,x (1 – 0,38) 1,700,000,000

EPS fof Lowe$ Companie* IIc, (EBIT* Interest E, xpqs?rowl x 0 * Tax Rate)

Shares Outstanding6yo

Shares Outstandiug6yy

(EBIT* $239,000,000) x (1 – 0.3S)

We substitute the appropriate values in the expression below and solve for EBIT:

(EBIT–Intefst,Expenser{d,x (l:fax,Bate) * (EBIT, InterestExp.lllllllns:ppy) x (t *TaxRate)

1,460,000,000

EBIT= $2,541,083,333

STEP 4: Analyze

Solving for the EBIT indilference level yrelds $2,541,083,333. This is the level at which both Home Depo! Inc. and Lowes Companies, Inc. have the same earnings per s-hare.

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Pl5-12 (Related to Checkpoint 15.2) (f,BIT-EPS analysis) Abe Forrester and three of his friends from (similar college have interested a group of venture capitalists in backing their business idea. The proposed to). operation would consist of a series ofretail outlets to disfiibute and service a full line of vacuum

cleaners and accessories. These stores would bs locatsd in Dallas, Houston, and San Antonio. To finauce the new venture two plans have been pmposed: . Plan A is an all-common-equity stnrcture in which $2.3 million dollars would be raised by selling 90,000 shares of common stock. . Plan B would involve issuing $l.l million in long-term bonds with an effective interestrate of 12.4 percent plus another $ I .2 million would be raised by selling 45,000 shares of common stock. The debt funds raised under Plan B have no fixed maturity date, in that this amount of financial leverage is considered a permanent part of the firm’s capital stnrcture.

Abe and his parhers plan to use a 40 percent tax rate in their analysis, and they have hired you on a consulting basis to do the following:

a. Find the EBIT indifference level associated with the two finaucing plans. b. Prepare a pro forma income statement for the EBIT level solved for in part a that shows that

a. The EBIT indifference level associated with the two financing plans is $fJ. lnounA to the nearest dollar.)

b. Complete the segment ofthe income $tatefirent forPlan A below: (Round income statement amounts to the nearest dollar except the EPS to the nearest cent.)

!to:T ru,l _ ., .EBrr $ l—-__l

EamingsBefore Taxes $lTT Less: Taxes at40Yo

Net Income

Number of Common Shares T—-_*l EPS $ T-::f

Complete the segment of tbe income statement forPlan B below: (Round income sktemerrt arnounts to the tearest dollar except the EPS to the nearest cent.)

,Bon{StgckPlal ._ ,EBIr $l I

Earnings Before Taxes $ m-

$T-*-__l

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Pr5-12 (similar to).

(cont.)

Less: Taxes at40Yo

Netluoome

NumberofCommon Shares

r;’r $r—_l

EPs .- s,E-I

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f,rrr^ PLU &usfrod /#.CU

(Related to Checkpoint 15.2) (EBIT-EPS analysis) Abe Forrester and three of his friends from college have interested a group of venture capitalists in backing theirbusiness idea. The proposed operation would consist of a series of retail outlets to distibute and service a full line of vacuum cleaners and accessories. These stores would be lacated in Dallas, Houston, and San Antonio. To finance the new venture two plans have been proposed:

‘ Plan A is an all-common-equlty structure in which $2.4 million dollars would be raised by selling 86,000 shares of common stock.

‘ Plan B would involve issuing $ 1.2 million in longterm bonds with an effective interest rate of 12.5 percent plus another S I .2 million would be raised by selling 43,000 shares of commor stock. The debt funds raised under Plan B have no fixed maturity date, in that this amount of financial leverage is considered a pennanent part of the firm’s capital sfucture.

Abe and his parhers plan to use a 36 percent tax rate in their analysis, and they have hired you on a consulting basis to do the following:

a. Find the EBIT indifference level associated with the two financing plans. b. Prepare a pro forma income stateinent for the EBIT level solved for in part a that shows that EPS will be the same regardless whether Plan A or B is chosen.

a. Find the EBIT indifference level associated with the two financing plans.

STEP 1: Picture the Problem

The EBIT-EPS chart (sometimes called the range of earnings chart) is the principal tool used to evaluate the effects of capital stucture choices on eanrings per share. The point of intersection of the two capital structure lines is sometimes called the EBIT-EPS indifference poiut. This point identifies the EBIT level at which the EPS will be the same regmdless of the financing plan chosen by the firm. This indifference point has major implications for financial planning. At EBIT amounts in excess of the EBIT indifference level, the financing plan with more leverage will generate a higher EPS. At EBIT amounts below the EBIT indifference level, the financing plan involving less leverage will geirerate a higher EpS.

STEP 2: Decide on a Solution Strategy

To find the break-even level of EBIT, we can modiff our interpretation of the equation below; instead of considering each side of the equation to rqrresent a financing plan we’re evaluating, we will consider each to be a description of one of our firms:

f,PS for StockPlan

(EBIT- Interest Expensesro*pr*) x (1 – Tax Rale) Shares Outstanding (Stock Plan)

STEP 3: Solve

EPS for Bond/Stock Pl*n

_ (EBlT,–lnterest Expenses.rapran),x (l * Tax Rate) Shares Outstan.tiqg (Bond plan)

We substitute the appopriate values in the expression below and solve for EBIT:

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tJ,6

Shares Outstanding (Stock Plan) Shares Outstdhifgq(Bond Plan)

IEBrT-,$0) x,(r – 0.36) * (EBrr- $15-0,000) x (,1,-b.*iL*1*g6,000 43,000 —tt’–ffii ‘

EBIT= $300,000

b. Prepare a pro forma income statement for the EBIT level solved for in part a that shows that EPS will be the same regardless whether Plan A or B is chosen.

Stock Plen

EBIT

Less: Interest Expense

Earnings Before Taxes

Less: Taxes at360/o

Net Income

Numberof Common Shares

EPS

BordlStockPlsn

(EBIT-tnterestExpels:stocrreran) x (1 -TaxRate) * (EBIT*qtgr:*Expensepgndptal x (1:TTRate)

300,000

(108,000)

$ 192,000 96,000

g 2.23

EBIT

Less: lnterest Expense

Earnings Before Taxes

Less: Taxes at36Yo

Net Income

Numberof Common Shares

EPS

$ 300,000 (150,000)

$ 150,000 (54,000)

96,000

43,000

2.23

STEP 4: Aaalyze

Solving for the EBIT indifference level yields $300,000. We can prove this by looking at the pro fonna income statements for each plan. We can also see this by using a chart:

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Pl5-14 (similar ro).

(EBIT-EPS break-even analysis) Home Dqrot,Inc. (HD) had 1.70 billion shares of common stock outstanding in 2008, whereas Lowes Companies, Inc. (LOW) had l.46billion shares outstanding. Assuming Home Depofs 2008 interest expense is $696 million, Lowes’interest expense is $239 million, and a 35 percent tax rate for both firms, what is their break-even level of operating income (i.e., the level of EBIT where EPS is the same for both firms)?

The EBIT indifference level is $[. lnounA to the nearest dollar.)

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