Help with BEC MCQ approach

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  • #161151
    SusanStudies
    Participant

    A company currently has 1,000 shares of common stock outstanding with zero debt. It has the choice of raising an additional $100,000 by issuing 9% long-term debt, or issuing 500 shares of common stock. The company has a 40% tax rate. What level of earnings before interest and taxes (EBIT) would result in the same earnings per share (EPS) for the two financing options?

    A. An EBIT of $27,000 would result in EPS of $10.80 for both.

    B. An EBIT of $27,000 would result in EPS of $7.20 for both.

    C. An EBIT of ($18,000) would result in EPS of ($7.20) for both.

    D. An EBIT of ($10,800) would result in EPS of ($7.92) for both.

    OK, Since this question is asking what EBIT is, I’m thinking I would have to try each EBIT amount and work all the way through the calculation of EPS for each alternative to see if Alt 1 EPS = Alt 2 EPS. Is there a quicker way to determine which EBIT works?

    The correct answer is (A) but if I’d started with letter (D) first, as Cindy from Yaeger suggests, I would have blown 6-7 mintues or more, trying to figure this out. I’m looking for a better approach if anyone has a suggestion.

    Thank you,

    AUD: 07/11/11 - Passed
    BEC: 08/27/11 - Passed
    FAR: 01/17/12 - Passed
    REG: 04/30/12; Re-take 7/16/12 - Passed

    FINISHED!!!!!!!!

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  • #291736
    rknight21
    Participant

    lol i have been seeing this question in my studies but ignored it because it seem more like an outlier kind of question. this morning i actually spent time trying to understand it since i have only 2 weeks more of studying…..now my approach is to quickly disregard C & D assuming EBIT wouldnt be negative…. now A & B's EBIT is the same so working for EPS shouldnt take more than 20 seconds tops…

    #291737
    kb24
    Participant

    EPS (equity) = EBIT * (1-tax rate)/# of shares after sale of equity

    EPS (debt) = (EBIT – interest paid on debt) * (1-tax rate)/# of shares

    Set up an equation equating the two and solve for EBIT. In this case

    EBIT (.6)/1500 = (EBIT-9000)(.6)/1000

    Once you have EBIT, you can solve for EPS.

    A general hint if you are trying to work backwards from the answers is to look for common factors amongst two or three of the answers. A lot of times where there are multiple parts to the answer two or more will have one part correct. In this case the first two answers have EBIT of $27K so those would be the first two I'd start with.

    FAR 4/1/11 - 89
    AUD 4/15/11 - 85
    REG 4/29/11 - 80
    BEC 5/13/11 - 85

    #291738
    SusanStudies
    Participant

    kb24, I swear you should go into teaching!!! Your responses and explanations are always so clear and very helpful. This now makes complete sense. The explanation provided in the software did not show how the $27k was determined…you did. THANKS!!

    Good luck rknight!

    AUD: 07/11/11 - Passed
    BEC: 08/27/11 - Passed
    FAR: 01/17/12 - Passed
    REG: 04/30/12; Re-take 7/16/12 - Passed

    FINISHED!!!!!!!!

    #3255144
    Zack Wright
    Participant

    For those wondering, here is how you solve for the $27,000 EBIT part:

    As stated before,

    Debt Option = Equity Option
    EPS (debt) = ((EBIT – interest paid on debt) * (1-tax rate)) / # of shares outstanding
    EPS (equity) = (EBIT * (1-tax rate)) / # of shares outstanding after the sale of equity

    Now, let's plug in what we know for the Debt Option and the Equity Option and do algebra!

    Debt Option = Equity Option
    [(EBIT – (9% x $100,000)) x (1-0.40)] / 1,000 = [EBIT – 0 Interest x (1-0.40)] / 1,500

    [(EBIT – $9,000) x 0.6] / 1,000 = [EBIT x 0.6] / 1,500

    [0.6 EBIT – $5,400] / 1,000 = 0.6 EBIT / 1,500

    0.6 EBIT – $5,400 = 0.4 EBIT

    YIKES! How did we get this??? (0.6 EBIT – $5,400 = 0.4 EBIT)
    To get rid of the 1,000 denominator on the left, we have to multiply BOTH denominators ONlY by 1,000.

    The left side of the equal sign simply just canceled out the 1,000 and removed it (again, the numerator is untouched).

    The right side is the fun side!

    0.6 EBIT x (1,000 / 1,500).

    0.6 EBIT x 0.66666666666….7

    0.4 EBIT for the right side. (in a basic calculator, do the math for 1000/1500 first, then multiply by 0.6.)

    Now, back to the algebra:

    From before:
    0.6 EBIT – $5,400 = 0.4 EBIT

    0.6 EBIT – 0.4EBIT = $5,400

    0.2 EBIT = $5,400

    EBIT = $5,400/0.2

    EBIT = $27,000

    Now, you can solve for EPS.

    #3255159
    Zack Wright
    Participant

    Here is how you solve for EPS once you know what EBIT is.

    Here is the formula to solve for EPS (normally):

    (Net Income – the Current Preferred Dividend)
    divided by
    Weighted Average Common Shares Outstanding

    We will not use this formula this time.

    To solve for EPS for this problem, you will use the same formula from earlier that we used to solve for EBIT.

    The difference this time is that WE KNOW what EBIT is! ($27,000)

    Just like with the balance sheet (A = L + E), both sides of the equal sign need to match.
    Debt Option = Equity Option

    Option 1—issue 9% debt:
    EPS (debt) = ((EBIT – interest paid on debt) * (1-tax rate)) / # of shares outstanding

    EPS (debt) = [($27,000 – ($100,000 × 9%)) x (1-0.4)] / 1,000 shares

    EPS (debt) = [($27,000 – $9,000) x (0.6)] / 1,000 shares

    EPS (debt) = [($27,000 – $9,000) x (0.6)] / 1,000 shares

    EPS (debt) = $10,800 / 1,000 shares

    EPS (debt) = $10.80 Earnings Per Share

    Option 2—issue 500 shares of common stock
    EPS (more equity) = ((EBIT – interest paid on debt) * (1-tax rate)) / # of shares outstanding after the sale of additional equity

    EPS (more equity) = [($27,000 – $0 interest) x (1-0.4)] / 1,500 shares

    EPS (more equity) = [$27,000 x 0.6] / 1,500 shares

    EPS (more equity) = $16,200 / 1,500

    EPS (more equity) = $10.80 Earnings Per Share

    Because the $10.80 matches for both, you know that everything is correct.

    What level of earnings before interest and taxes (EBIT) would result in the same earnings per share (EPS) for the two financing options?

    For EPS for both of the financing options to be the same ($10.80 earnings per share), our EBIT needs to be $27,000.

    For analysis, remember that EBIT = (Sales – Variable Costs) – Fixed Costs
    aka
    the Contribution Margin – Fixed Costs.

    This is probably the toughest M/C question in all of BEC folks! If you can solve this one, you can solve ANY of the BEC questions! I PROMISE!!

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