Hammel Corporation is comparing two different capital structures, an all-equity plan and alevered plan. Under the all-equity plan, Hammel would have 80,000 shares of stock outstanding.Under the levered plan, there would be 50,000 shares outstanding and $300,000 in debtoutstanding. A share of stock is valued to be $10 regardless of the plan. The interest rate on the debt is 8%. Ignoring taxes, at EBIT equal to $100,000, shareholders of Hammel Corporation would
A) prefer the levered plan.
B) be indifferent to which plan is selected.
C) prefer the all-equity plan.
D) which plan is better cannot be determined with the information provided

Question

Quizplus · Accepted Answer

To determine which plan shareholders would prefer, we need to compare the earnings per share (EPS) under each plan.

Under the all-equity plan, Hammel would have 80,000 shares outstanding, so EPS = EBIT / number of shares = $100,000 / 80,000 = $1.25.

Under the levered plan, there would be 50,000 shares outstanding, so EPS = (EBIT - Interest) / number of shares = ($100,000 - ($300,000 x 0.08)) / 50,000 = $0.94.

Therefore, shareholders would prefer the levered plan because it would result in a higher EPS.

Hammel Corporation Is Comparing Two Different Capital Structures, an All-Equity