EBIT–EPS Analysis. The Morton Company is planning to invest $10 million in an expansion program which is expected to increase earnings before interest and taxes by $2.5 million. The company currently is earning $5 per share on 1 million shares of common outstanding. The capital structure prior to the investment is:
Debt $10,000,000
Equity 30,000,000
$40,000,000
The expansion can be financed by sale of 200,000 shares at $50 net each, or by issuing long-term debt at a 6 percent interest cost. The firm’s recent profit and loss statement was as follows:
Sales $101,000,000
Variable cost $ 60,000,000
Fixed cost 30,500,000
$ 90,500,000
Earnings before interest and taxes $ 10,500,000
Interest 500,000
Earnings before taxes $ 10,000,000
Taxes (50%) 5,000,000
Earnings after taxes $ 5,000,000
(a) Assuming the firm maintains its current earnings and achieves the anticipated earnings from the expansion, what will be the earnings per share (1) if the expansion is financed by debt? (2) if the expansion is financed by equity? (b) At what level of earnings before interest and taxes will the earnings per share under either alternative be the same amount? (c) The choice of financing alternatives influences the earnings per share. The choice might also influence the earnings multiple used by the market. Discuss the factors inherent in the choice between the debt and equity alternatives that might influence the earnings multiple. Be sure to indicate the direction in which these factors might influence the earnings multiple. (CMA, adapted.)