Question

After graduating from college, you decide to set up your own company, requiring a $120,000 initial investment. You can bring that money yourself (making you thus hold 120,000 shares of $1), but alternatively, you could borrow $40,000 at an interest rate of 4% per annum and thus only bring in $80,000. Assume that there is no asset to be depreciated and that the applicable tax rate is 30%.

a) If the estimated annual EBIT for your business is $12,000, which financing alternative would you adopt?

b) Looking at the EPS, what is the EBIT indifference level of your business if you opt for the debt + equity financing?

c) Explain the results

Answer 1

Question A

Alternative 1 - Without Borrowing - Number of shares = 120000

Particulars	Amount
EBIT	12000
Interest	0
Earning Before Tax	12000
Tax @30%	3600
Earning After Tax	8400
Number of Shares	120000
EPS	0.07

Alternative 2 - With Borrowing - Number of Shares = 80000

Particulars	Amount
EBIT	12000
Interest (40000*4%)	1600
Earning Before Tax	10400
Tax @30%	3120
Earning After Tax	7280
Number of Shares	80000
EPS	0.091

Since Earning Per Share (EPS) is more in alternative 2 (Borrowing) we will adapt alternative 2

Question B

Let the EBIT Level be x

We will find EPS under both the alternative using EBIT as x and then equate both the equations to find X

EPS under Alternative 1 (X-Interest)*(1-t)/Number of shares

Equation 1 = (X-0)*(1-0.30)/120000 = 0.70x / 120000

EPS under Alternative 2 (X-Interest)*(1-t)/Number of shares

Equation 2 = (X-1600)*(1-0.30)/Number of Shares = 0.70x - 1120 / 80000

Now we will equate both the equation 1 and 2

0.70x / 120000 = (0.70x - 1120) / 80000

0.70x / 3 = (0.70x - 1120) / 2

1.4x = 2.1x - 3360

0.70x = 3360

x = 4800

Therefore At EBIT level of 4800 both the alternative are at indifference level

Question C - Explanation

At EBIT level of 4800 we are indifferent between both the alternative, if the EBIT rises above 4800 debt financing will improve the EPS but if EBIT is less than 4800 it will result in fall in EPS

Particulars	Alternative 1	Alternative 2
EBIT	4800	4800
Interest	0	1600
Earning Before Tax	4800	3200
Tax @30%	1440	960
Earning After Tax	3360	2240
Number of Shares	120000	80000
EPS	0.028	0.028