9. Suppose that you are considering a stock investment in one of two firms (AllDebt, Inc., and AllEquity, Inc.), both of which operate in the same industry and have identical IBITDA of $6.2 million and operating incomes of $5 million. AllDebt, Inc. finances its $12 million in assets with $11 million in debt (on which it pays 10 percent interest, or interest payments of $1.1 million) and $1 million in equity. With $6.2 million of EBITDA AllDebt Inc. may deduct up to $1.86 million ($6.2 x 30 percent) of interest expense for tax purposes. Thus, AllDebt Inc. is allowed to deduct all of its interest expense. AllEquity, Inc. finances its $12 million in assets with no debt and $12 million in equity. Both firms pay 21 percent tax on their taxable income. Calculate the income that each firm has available to pay its debt and stockholders (the firm's asset funders) and the resulting returns to these asset funders for the two firms. Refer to Example 2-5 on page 44.
							AllDebt		AllEquity
Equity							$1,000,000		$12,000,000
Asset-funders' investment (assets)							$12,000,000		$12,000,000
Earnings before interest, taxes, depreciation, and amortization (EBITDA)							$6,200,000		$6,200,000
Less: Depreciation and amortization							$1,200,000		$1,200,000
Operating income (EBIT)
Less: interest							$1,100,000		$0
Taxable income
Tax rate							21%		21%
Less: Taxes
Net income
Income available for asset funders (Operating income - Taxes)
Return on asset-funders' investment (return on assets)
Return on equity (Net income / Equity) (AOL focus for course.)
Lesson: Debt has a tax advantage for a profitable company. While the advantage of debt shows up slightly in Return on Assets, it has a dramatic impact on Return on Equity. However, debt can lead to bankruptcy if a company has a few unprofitablel years.

EXAMPLE 2-2 LG2-1 For interactive versions of this example, log in to Connect or go to Impact of Capital Structure on a Firm's EPS Consider a firm with an EBIT of $750,00O. The firm finances its assets with $1,600,000 mhhe.com/Cornett5e. debt (costing 5 percent and all is tax deductible) and 200,000 shares of stock selling at $6.00 per share. To reduce the firm's risk associated with this financial leverage, the firm is considering reducing its debt by $600,000 by selling an additional 100,000 shares of stock. The firm's tax rate is 21 percent. The change in capital structure will have no effect on the operations of the firm. Thus, EBIT will remain at $750,000. Calculate the dilution in the firm's EPS from this change in capital structure SOLUTION: The EPS before and after this change in capital structure isillustrated below: Before Capital Structure Change After Capital Structure Change Change $750,000 $750,000 EBIT ($1,600,000 x 0.05) ($1,000,000 x 0.05) Less: Interest 80,000 50,000 $670,000 $700,000 EBT Less: Taxes (21 %) 140,700 147,000 $529,300 $553,000 Net income Divided by # of shares 200,000 300,000 $ $ EPS 2.65 1.84 The change in capital structure would dilute the stockholders' EPS by $0.81 Similar to Problems 2-5, 2-6, 2-23, 2-24 EXAMPLE 2-2 LG2-1 For interactive versions of this example, log in to Connect or go to Impact of Capital Structure on a Firm's EPS Consider a firm with an EBIT of $750,00O. The firm finances its assets with $1,600,000 mhhe.com/Cornett5e. debt (costing 5 percent and all is tax deductible) and 200,000 shares of stock selling at $6.00 per share. To reduce the firm's risk associated with this financial leverage, the firm is considering reducing its debt by $600,000 by selling an additional 100,000 shares of stock. The firm's tax rate is 21 percent. The change in capital structure will have no effect on the operations of the firm. Thus, EBIT will remain at $750,000. Calculate the dilution in the firm's EPS from this change in capital structure SOLUTION: The EPS before and after this change in capital structure isillustrated below: Before Capital Structure Change After Capital Structure Change Change $750,000 $750,000 EBIT ($1,600,000 x 0.05) ($1,000,000 x 0.05) Less: Interest 80,000 50,000 $670,000 $700,000 EBT Less: Taxes (21 %) 140,700 147,000 $529,300 $553,000 Net income Divided by # of shares 200,000 300,000 $ $ EPS 2.65 1.84 The change in capital structure would dilute the stockholders' EPS by $0.81 Similar to Problems 2-5, 2-6, 2-23, 2-24