Question

In: Finance

NoNuns Cos. has a 21 percent tax rate and has $299,520,000 in assets, currently financed entirely...

NoNuns Cos. has a 21 percent tax rate and has $299,520,000 in assets, currently financed entirely with equity. Equity is worth $32 per share, and book value of equity is equal to market value of equity. Also, let’s assume that the firm’s expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities as shown below:

State Recession Average Boom
Probability of state 0.20 0.55 0.25
Expected EBIT in state $ 4.00 million $ 9.00 million $ 16.00 million


The firm is considering switching to a 20-percent-debt capital structure, and has determined that it would have to pay an 10 percent yield on perpetual debt in either event. What will be the break-even level of EBIT? (Enter your answer in dollars not in millions. Do not round intermediate calculations and round your final answer to the nearest whole dollar amount.)


What is the EBIT?

Solutions

Expert Solution

Calculation of Breakeven level of EBIT

Breakeven level of EBIT is that point where Earning per share before change in capital structure and after change in capital structure is same.

Calculation of total number of shares outstanding = Assets Value / Current share price

= 299,520,000 / 32

= 9,360,000

Expected EBIT of company = Sum of (Probability of state * Expected EBIT)

= (0.20 * 4 million) + (0.55 * 9 million) + (0.25 * 16 million)

= 0.8 + 4.95 + 4

= 9.75 million

If firm is considering switching to a 20-percent-debt capital structure:

Calculation of Amount of Debt

Debt Value = Assets Value * 20%

= 299,520,000 * 20%

= 59,904,000

Interest on Debt = 59,904,000 * 10%

= 5,990,400

If proceeds from debt issue after the capital structure change is used to repurchase shares then

Number of share repurchased = Debt Value / Current share Price

= 59,904,000 / 32

= 1,872,000

Number of share after repurchase = Shares outstanding before - Number of share repurchased

= 9,360,000 - 1,872,000

= 7,488,000

Now we will calculate Breakeven EBIT with the help of calculations above

Earnings per share before change in capital structure = Earnings per share after change in capital structure

EBIT / 9,360,000 = (EBIT -  5,990,400) / 7,488,000

EBIT * (7488000 / 9360000) = (EBIT - 5990400)

0.80 * EBIT = EBIT – 5990400

==> EBIT - 0.80EBIT = 5990400

0.20EBIT = 5990400

Break even EBIT = 5990400 / 0.20

= 29,952,000  


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