Question

High Sky Inc. a hot-air balloon manufacturing firm, currently has the following simplified balance sheet:

		Assets		Liabilities and Capital
Total assets		$800,000		Bonds (9% interest)		$500,000
				Common stock at par ($4), 50,000 shares		$200,000
				outstanding
				Contributed capital in excess of par		$50,000
				Retained earnings		$50,000
				Total liabilities and capital		$800,000

The company is planning an expansion that is expected to cost $800,000. The expansion can be financed with new equity (sold to net the company $7 per share) or with the sale of new bonds at an interest rate of 12 percent. (The firm’s marginal tax rate is 40%.) Use Table V to answer the questions.

• Compute the indifference point between the two financing alternatives. Round your answer to the nearest dollar.
  $  

• If the expected level of EBIT for the firm is $250,000 with a standard deviation of $60,000, what is the probability that the debt financing alternative will produce higher earnings than the equity alternative? (EBIT is normally distributed.) Round your answer to two decimal places. 10.123% would be entered as 10.12
    %

• If the debt alternative is chosen, what is the probability that the company will have negative earnings per share in any period? Round your answer to two decimal places.

Answer 1

(a) Computation of indifference point between two financing alternatives

Indifference point is the level of EBIT at which EPS of both the equity financing option and debt financing option will be same.

EPS of equity financing = EBIT (1-t) / (Old shares + New shares)

Number of old shares = 50,000

Number of new shares issued = New capital raised / Share price of new capital

= $800,000 / $7

= 114,285 shares

EPS of debt financing = [(EBIT- Interest) (1-t)] / Old shares

Interest = $800,000 * 12% = $96,000

At indifference point, EPS equity = EPS debt

[EBIT (1-0.4) / (50,000+114,285)] = [(EBIT - 96,000)(1-0.4)] / 50,000

EBIT = $137,730

(b) Computation of probability of debt financing alternative producing higher earnings than equity alternative

Expected EBIT = $250,000

Standard deviation = 60,000

Z = (Indifferene EBIT - Expected EBIT) / Standard deviation

= (137,730 - 250,000) / 60,000

= - 1.871

Looking at the value of Z = -1.871 in the normal distribution table, the probability of debt financing alternative producing higher earnings than equity alternative is 3.07%.

(c) Computation of probability of negative earnings per share if debt alternative is chosen

Z = (Interest - Expected EBIT) / Standard deviation

= (96,000 - 250,000) / 60,000

= -2.566

Looking at the value of Z = -2.566 in the normal distribution table, the probability of negative earnings per share if debt alternative is chosen is 0.51%.