Lever Brothers has a debt ratio (debt to assets) of 40%. Management is wondering if its current capital structure is too conservative. Lever Brothers’ present EBIT is $3 million, and profits available to common shareholders are $1,560,000, with 342,857 shares of common stock outstanding. If the firm were to instead have a debt ratio of 60%, additional interest expense would cause profits available to stockholders to decline to $1,440,000, but only 228,571 common shares would be outstanding. What is the difference in EPS at a debt ratio of 60% versus 40%?

Question

Lever Brothers has a debt ratio (debt to assets) of 40%. Management is wondering if its current capital structure is too conservative. Lever Brothers’ present EBIT is $3 million, and profits available to common shareholders are $1,560,000, with 342,857 shares of common stock outstanding. If the firm were to instead have a debt ratio of 60%, additional interest expense would cause profits available to stockholders to decline to $1,440,000, but only 228,571 common shares would be outstanding. What is the difference in EPS at a debt ratio of 60% versus 40%?

Answer 1

To find the difference in EPS (earnings per share) at a debt ratio of 60% versus 40%, we need to calculate the EPS for each scenario and then compare them.

First, let's calculate the EPS at the current debt ratio of 40%. EPS is calculated by dividing the profits available to common shareholders by the number of common shares outstanding.

EPS at 40% debt ratio = Profits available to common shareholders / Number of common shares outstanding
EPS at 40% debt ratio = $1,560,000 / 342,857 shares

Next, let's calculate the EPS at the proposed debt ratio of 60%. In this case, we need to consider the additional interest expense that would cause a decline in profits available to stockholders. We'll subtract this additional interest expense from the profits available to common shareholders before calculating EPS.

Profits available to common shareholders at 60% debt ratio = $1,440,000
Additional interest expense = EBIT at 40% debt ratio - EBIT at 60% debt ratio
Additional interest expense = $3,000,000 - EBIT at 60% debt ratio

Now, let's calculate the EPS at the 60% debt ratio using the adjusted profits available to common shareholders.

EPS at 60% debt ratio = (Profits available to common shareholders - Additional interest expense) / Number of common shares outstanding
EPS at 60% debt ratio = ($1,440,000 - Additional interest expense) / 228,571 shares

Finally, we can calculate the difference in EPS between the two debt ratios.

Difference in EPS = EPS at 60% debt ratio - EPS at 40% debt ratio

By following these calculations, you will be able to determine the difference in EPS at a debt ratio of 60% versus 40% for Lever Brothers.