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.

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

Answer 1

Since Face value of equity share is not given, hence it is assumed to be $10 per share.

Current Number of equity shares outstanding = 1,200,000

Current total Equity share capital = 1,200,000 x $10 = $12,000,000

Existing Debt = $8,000,000

Additional Debt borrowed = $2,000,000

Hence, total buyback of shares that can be made = $2,000,000

Hence, equity share capital after buyback = $12,000,000 - $2,000,000 = $10,000,000

Hence, No of equity shares outstanding after buyback = $10,000,000 / $10 = 1,000,000

Breakeven point refers to the level of EBIT where Earnings per share (EPS) under 2 financing plans are same.

Let us assume the EBIT under both the financing plans be 'x'

Particulars	Plan 1 (Current capital Structure)	Plan 2 (Addition debt borrowing to buy back common stock
EBIT	x	x
Less: Interest @5%	400,000	500,000
Less Bankruptcy cost	0	300,000
Profit before tax	x - 400,000	x - 800,000
Less Tax @ 40%	40%*(x - 400,000)	40%*(x - 800,000)
Profit after tax	60%*(x - 400,000)	60%*(x - 800,000)
No. of shares outstanding	1,200,000	1,000,000
Earnings per share	60%*(x - 400,000) / 1,200,000	60%*(x - 800,000) / 1,000,000

Since, Breakeven point refers to the level of EBIT where Earnings per share (EPS) under 2 financing plans are same, hence,

60%*(x - 400,000) / 1,200,000 = 60%*(x - 800,000) / 1,000,000

Solving the above equation, we get the value of x = 2,800,000

Hence, breakeven EBIT of the two capital structure is $2,800,000