Edsel Research Labs has $27 million in assets. Currently, half of these assets are financed with long-term debt at 5 percent and half with common stock having a par value of $10. Ms. Edsel, the vice-president of finance, wishes to analyze two refinancing plans, one with more debt (D) and one with more equity (E). The company earns a return on assets before interest and taxes of 5 percent. The tax rate is 30 percent.
Under Plan D, a $6.75 million long-term bond would be sold at an interest rate of 11 percent and 675,000 shares of stock would be purchased in the market at $10 per share and retired. Under Plan E, 675,000 shares of stock would be sold at $10 per share and the $6,750,000 in proceeds would be used to reduce long-term debt.
a. How would each of these plans affect earnings per share? Consider the current plan and the two new plans. Which plan(s) would produce the highest EPS?
b. Which plan would be most favorable if return on assets increased to 8 percent? Compare the current plan and the two new plans. What has caused the plans to give different EPS numbers?
c. Assuming return on assets is back to the original 5 percent, but the interest rate on new debt in Plan D is 7 percent, which of the three plans will produce the highest EPS? Why?