Question

A company has 5.56 million common shares outstanding and $65 million of debt with an interest rate of 5.8%. The company wants to raise another $52 million. It can do so by selling an additional 2.78 million shares of common stock (the equity plan) or by taking out a bank loan with an interest rate of 7.1% (the debt plan). The company has no preferred stock. The corporate tax rate is 21%. At what level of EBIT would the company have the same earnings per share (EPS) under either plan? Specify the answer in $ mln., to the nearest $0.01 mln., drop the $ symbol.

Answer 1

A company has 5.56 million common shares outstanding and $65 million of debt with an interest rate of 5.8%. The company wants to raise another $52 million. It can do so by selling an additional 2.78 million shares of common stock (the equity plan) or by taking out a bank loan with an interest rate of 7.1% (the debt plan). The company has no preferred stock. The corporate tax rate is 21%. At what level of EBIT would the company have the same earnings per share (EPS) under either plan? Specify the answer in $ mln., to the nearest $0.01 mln., drop the $ symbol.

Existing Debt amount = $65 million

Interest on Existing Debt amount = $65 million*5.8%

=$3.77 million

Interest on new Debt = $52 million*7.1%

=$3.692 million

- Formula for Breakeven EBIT at which EPS for both Plan will be Equal:-

EPS of Equity Plan = EPS of Debt Plan

(EBIT-Interest)*(1-Tax rate)/No of Shares = (EBIT-interest)*(1-Tax rate)/No of Shares

(EBIT- 3.77)*(1-0.21)/(5.56 + 2.78) = (EBIT- (3.77+3.692))*(1-0.21)/5.56

(EBIT- 3.77)*(0.79)/(8.34) = (EBIT- 7.462)*(0.79)/(5.56)

0.79EBIT-2.9783/8.34 = 0.79EBIT-5.89498/5.56

5.56(0.79EBIT-2.9783) = 8.34(0.79EBIT-5.89498)

4.3924EBIT - 16.559348 = 6.5886EBIT - 49.1641332

49.1641332- 16.559348 = 6.5886EBIT - 4.3924EBIT

32.6047852 = 2.1962EBIT

EBIT = 14.846

So, the level of EBIT would the company have the same earnings per share (EPS) under either plan is $14.85 million

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