Continental Carriers, Inc case
Continental Carriers, Inc.
1. Consider the EPS-EBIT chart.
a. Why do the lines for the stock plan and the bond plan have different slopes? What’s the significance of this difference?
Because the calculation of EPS is net income divided by outstanding shares, two lines for the stock plan and bond plan have different slope. The significant difference is that two variables are different on bond and stock plan. If we assume two plans have same EBIT, a net income shows different value on two plans due to the interest expense of bond, which is 5.0 million dollar in every year till maturity. Another compounding that used to calculate EPS is outstanding shares that also differ on two plans. On bond plan, outstanding shares would be 4.5 million whereas for stock plan is 7.5 million.
b. Why are EPS equal under the two plans at an EBIT of $12.5 million? Which plan would produce the higher EPS at $10 million? At $15 million?
Although the stock and bond plans have a same EPS at an EBIT of $12.5 million, equation is different. The equation is shown below:
Bond plan: EPS=(Net income-Dividends on preffered stock)/(Average outstanding shares)=$4'500'000/4'500'00=$1.0
Stock plan:EPS= $7'500'000/7'500'000=$1.0
According to the graph and equation, If EBIT increases above $12.5 million, bond plan will produce higher EPS because increasing debt affects to increase leverage. If EBIT decrease below $12.5 million, stock plan will produce higher EPS. Exact values are shown below.
EBIT Bond Plan / EPS/ Higher Stock plan /EPS/
$10’000’000 $0.67 < $0.80
$15’000’000 $1.33 > $1.20

c. Which plan produces the greater percentage increase (or decrease) in EPS for a percentage increase (or decrease) in EBIT? Why increased leverage is considered more risky. Why is financial leverage considered to be a “two edged sword?”
Bond plan produces the