In: Finance
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?
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