Question

DIY has EBIT of $4 million per year forever. Its cost of equity is 12% and tax rate is 40%. There are 1.2 million shares outstanding. It also has $8 million (face value) perpetual debt which pays annual coupon of 5%, and is trading at 125% of the face value. DIY wants to borrow new perpetual debt of $2 million at current cost of debt to buy back its common stocks. Due to this new debt, there will be present value of bankruptcy cost of $300,000.

1.Calculate the equity value, firm value, stock price, debt equity ratio, and EPS under the current capital structure.

2.Calculate the equity value, firm value, stock price, debt equity ratio, and EPS under the new capital structure.

3.What is the breakeven EBIT of the two capital structures?

Answer 1

Income Statement of DIY

Particulars	Amount under Current Capital Structure	Amount under NewCapital Structure
Earnings Before Interest & Tax (EBIT)	4,000,000	4,000,000
Less: 5% Interest on Current Debt (8,000,000) Less: 5% Interest on New Debt (2,000,000)	(400,000) ----	(400,000) (100,000)
Earnings Before Tax (EBT)	3,600,000	3,500,000
Less: Tax @ 40%	(1,440,000)	(1,400,000)
Earnings After Tax (EAT)	2,160,000	2,100,000

Calculation of equity value, firm value, stock price, debt equity ratio, and EPS under the current capital structure and new capital structure

Particulars	Under Current Capital Structure	Under New Capital Structure
Equity Value	=18,000,000	=17,500,000
Firm Value Firm Value = Equity Value + Debt Value	= 18,000,000 + 8,000,000 = 26,000,000	= 17,500,000 + (8,000,000 + 2,000,000) = 27,500,000
Stock Price	= 15	= 14.58
Debt-Equity Ratio	= 0.44	= 0.57
EPS (Earning per Share)	= 1.8	= 1.75

Calculation of Breakeven EBIT under the current capital structure and new capital structure

Particulars	Under Current Capital Structure	Under New Capital Structure
Breakeven EBIT Breakeven EBIT is that level of EBIT at which EPS is Zero (0).	EBIT= 400,000	EBIT= 400,000