Case Study 2

Read the case study given below and use your knowledge to answer the questions that follow. Examples are to be provided in places where possible.

EBIT-EPS Analysis and Choice of Capital Structure

The current COVID 19 pandemic showed a huge increase in the demand for Personal Protective Equipment's (PPE) that included face masks, N95 respirators and medical clothing. Xixian Ltd that specialises in production of N95 respirators had stocks of the N95 respirators which were all purchased by health departments and people within two weeks after the outbreak of Coronavirus and this taught a lesson to Xixian Limited to produce the N95 respirators in huge amounts for any sudden future needs. With the current capacity of its manufacturing plants, it is very difficult to produce a high quantity of the respirators so Xixian Limited is now considering to buy a bigger respirator producing plant that would cost them $2 million. This new investment is expected to generate a permanent increase in the earnings before interest and taxes of $400,000 per annum. The current earnings before interest and taxes is $0.8million. Xixian Limited's current capital structure consists of contracted debt and equity. The company has 0.1 million preference shares which are traded in the market for $16 each and pay a fixed annual dividend of 8%. Xixian Limited's contracted debt comprises of $1,500,000 of issued bonds that pays 14% per annum. The firm currently has 0.45 million ordinary shares have been issued and are trading at $20 per share. The tax regulation mandates a 25.00% corporate tax rate for Xixian Limited.

Required:

A) To fund the acquisition of the new 'bigger respirator producing plant' entirely, Xixian Limited can issue new ordinary shares (New Equity Plan) at the current market price. What is the impact on EPS if new shares are issued to fund the expansion?

B) To fund the acquisition of the new 'bigger respirator producing plant' entirely, Xixian Limited can raise new debt at 17.00% interest rate (New Debt Plan). What is the impact on EPS of using debt rather than a new equity issue?

C) Calculate the EPS indifference point of New Equity plan and New Debt Plan

D) Comment on the level of Financial Risk of choosing the New Debt Capital structure over the New Equity Capital structure.