This mini case requires students to focus on the impact of capital structure alternatives on earnings per share at various levels of EBIT, but also directs them to consider the implications of the various formulations of the Modigliani and Miller propositions.
1. Why should GESS expect to pay a higher rate of interest if it borrows $4,000,000 rather than $2,000,000?
2. Estimate earnings per share for Plan A and Plan B at EBIT levels of $800,000, $1,000,000 and $1,200,000.
3. How do taxes impact your findings in Question 2? By how much would the value of GESS increase or decrease as a result of choosing Plan A or Plan B?
4. At what level of EBIT would EPS be the same under either plan?
5. Suppose GESS’s management is fairly confident that EBIT will be at least $1,000,000. Which plan would the firm be most likely to choose?
6. Assume that GESS has no internal sources of financing and does not pay dividends. Under these conditions, would pecking order theory influence the decision to use Plan A or Plan B?
7. We assumed that the decision to use more or less debt did not change the price of the stock. Under real-life conditions, how would the decision be likely to affect the stock price at first, and later, if management’s optimism turned out to be justified?
8. Challenge question. What if 40% of GESS’s stock was owned by a large pharmaceutical company, and this company also purchased 40% of the privately placed debt? Would this situation influence the decision to use Plan A or Plan B?