Cain Auto Supplies and Able Auto Parts are competitors in the aftermarket for auto supplies. The separate capital structures for Cain and Able are presented below.

a. Compute EPS if EBIT are $20,000, $27,000, and $55,000 (assume a 20 percent tax rate). (Round the final answers to 2 decimal places. Do not leave any empty spaces; input a 0 wherever it is required.)

b. What is the relationship between EPS and level of EBIT?

c. If the cost of debt went up to 11 percent and all other factors remained equal, what would be the indifference point for EBIT?

Break-even level

b.

Operating profit (EBIT) return on assets ($300,000) = 6.67%, ($20,000 / $300,000), 9% and 18.33% at the respective levels of EBIT. When the before-tax return on assets (EBIT / Total Assets) is less than the cost of debt (9%), Cain does better with less debt than Able. When before-tax return on assets is equal to the cost of debt, both firms have equal EPS. This would be where the method of financing has a neutral effect on EPS. As return on assets becomes greater than the interest rate, financial leverage becomes more favorable for Able.

c.

11% $300,000 = $33,000 indifference point.

\begin{tabular}{cccc} \begin{tabular}{l} Debt @ 9\% \\ Common stock \end{tabular} & \begin{tabular}{r} $100,000 \\ 200,000 \end{tabular} & \begin{tabular}{c} Debt @ 9\% \\ Common stock \end{tabular} & $200,000 \\ Total & & Total & 100,000 \\ Common shares & & & $300,000 \\ \hline \end{tabular} \begin{tabular}{|c|c|c|c|c|} \hline & \multicolumn{2}{|c|}{ Cain } & \multicolumn{2}{|c|}{ Able } \\ \hline EPS at $20,000 & $ & 0.44 & $ & 0.16 \\ \hline EPS at $27,000 & $ & 0.72 & $ & 0.72 \\ \hline EPS at $55,000 & $ & 1.84 & $ & 2.96 \\ \hline \end{tabular} Explanation 1. Earnings before interest and taxes is less than cost of debt. 2. Earnings before interest and taxes equals cost of debt. 3. Earnings before interest and taxes is greater than cost of debt. Cain does better Both are at equilibrium Able does better $33,000