A firm has a current capital structure consisting of $400,000 of 12 percent annual interest debt and 50,000 shares of common stock. The firm's tax rate is 40 percent on ordinary income. If the EBIT is expected to be $200,000, two EBIT-EPS coordinates for the firm's existing capital structure are ________.
A) ($36,000, $0) and ($200,000, $3.04)
B) ($48,000, $0) and ($200,000, $1.82)
C) ($0, $48,000) and ($200,000, $1.82)
D) ($152,000, $3.50) and ($150,000, $1.82)

Question

Quizplus · Accepted Answer

First, we need to calculate the firm's earnings per share (EPS) at different levels of EBIT using the existing capital structure.

At EBIT = $36,000:

Interest expense = 0.12 x $400,000 = $48,000
Taxable income = $36,000 - $48,000 = -$12,000
Net loss = -$12,000 x (1 - 0.4) = -$7,200
EPS = -$7,200 / 50,000 = -$0.144

At EBIT = $200,000:

Interest expense = 0.12 x $400,000 = $48,000
Taxable income = $200,000 - $48,000 = $152,000
Net income = $152,000 x (1 - 0.4) = $91,200
EPS = $91,200 / 50,000 = $1.824

Therefore, the two EBIT-EPS coordinates for the firm's existing capital structure are ($48,000, $0) and ($200,000, $1.82), which are closest to option B.

A Firm Has a Current Capital Structure Consisting of $400,000