Question

A firm has the following information for the last two years. Calculate its degree of financial leverage.

	This year	Last year
Sales	$1,500,000	$1,300,000
Operating costs	$900,000	$800,000
Net income	$150,000	$120,000
Number of shares outstanding	50,000	50,000

Allegra Inc. has one million shares outstanding. The company is considering the issue of debt of $15 million. The interest rate on this new debt issue will be 8%, and the number of shares after the debt issue will be reduced to 500,000. Given a corporate tax rate of 40%, what is the EBIT that will cause the firm's earnings per share to be indifferent between issuing and not issuing debt?

Answer 1

This year:

Degree of Financial Leverage = EBIT/(EBIT-Interest)

EBIT = Sales - Operating costs

= $1,500,000 - $900,000

= 600,000

Interest = 0

Degree of Financial Leverage = 600,000 / 600,000

= 1

Applying same formula for Degree of Financial Leverage for last year is = 1.

EBIT indifference point:

For alternative 1: No debt

(X - I₁) (1-T) - PD = (X - 0) (1-.4) - 0 / 1,000,000

S₁

For alternative 2: with debt

(X - I₂) (1-T) - PD = (X - 1,200,000) (1-.4) - 0 / 500,000  

S₂

Equate alternative 1 = alternative 2 and find X - EBIT indifference point

.6 X / 1,000,000 = .6X - 720,000 / 500,000

X = 2,400,000 (EBIT indifference point).

Where:

X = EBIT indifference

I₁ = Fixed interest charge under alternative 1.

I₂ = Fixed interest charge under alternative 2.

PD = Preference dividends

T = Corporate Tax rate

S₁ = Number of equity shares outstanding in alternative 1.

S₂ = Number of equity shares outstanding in alternative 2.