Question

Suppose the BDJ Corporation has decided in favor of a capital restructuring that involves increasing its existing $80 million in debt to $125 million. The interest rate on the debt is 9 percent and is not expected to change. The firm currently has 10 million shares outstanding, and the price per share is $45. If the restructuring is expected to increase the ROE, what is the minimum level for EBIT that BDJ’s management must be expecting? Ignore taxes for this problem.

Has to be done in Excel

Answer 1

Solution :-

Scenario 1). The amount of debt is $ 80 Million and number of outstanding shares are 10 Million. (existing capital structure) :-

Earnings per share (EPS) = (EBIT - Interest on debt) / Number of outstanding shares.

= (EBIT - 80 Million * 9 %) / 10 Million

= (EBIT - 7.20 Million) / 10 Million.

Scenario 2). The amount of debt is $ 125 Million and number of outstanding shares are 9 Million. (New capital structure) :-

Number of outstanding shares (after capital restructuring) = Total number of shares (before restructuring of capital structure) - (Change in debt level / Price per share outstanding).

= 10 Million - [ (125 Million - 80 Million) / 45 ]

= 10 Million - (45 Million / 45)

= 10 Million - 1 Million

= 9 Million number of shares.

Accordingly, Earnings per share (EPS) = (EBIT - Revised Interest on debt) / Revised Number of outstanding shares.

= (EBIT - 125 Million * 9 %) / 9 Million

= (EBIT - 11.25 Million) / 9 Million.

Now, to calculate the minimum level of of EBIT, The EPS equations under the two scenarios need to be equated, thereby, resulting in this situation as presented at below:-

(EBIT - 7.20 Million) / 10 Million. = (EBIT - 11.25 Million) / 9 Million.

9 Million * (EBIT - 7.20 Million) = 10 Million * (EBIT - 11.25 Million) Applying cross-multiplication rule..

9 Million * EBIT - 64.80 Million = 10 Million * EBIT - 112.50 Million

112.50 Million - 64.80 Million = 10 Million * EBIT - 9 Million * EBIT

47.7 Million = 1 Million * EBIT

EBIT = 47.7 Million / 1 Million

EBIT = 47.7 Million i.e., $ 47,70,00,00   ( 1 Million = 1000000, accordingly 47.7 Million = 47.7 * 1000000 = 47,70,00,00)

Conclusion :- Minimum level of Earnings before interest and tax (EBIT) = $ 47,70,00,00 i.e., $ 47.7 Million.