Question

GTB, Inc., has a 20 percent tax rate and has $85,656,000 in assets, currently financed entirely with equity. Equity is worth $6 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 Pessimistic Optimistic

Probability of state 0.44 0.56

Expected EBIT in state $ 4.90 million $ 18.90 million

The firm is considering switching to a 25-percent-debt capital structure, and has determined that it would have to pay a 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.)

EBIT $ 8,565,600.

Answer 1

SOLUTION:

From given data,

GTB, Inc., has a 20 percent tax rate and has $85,656,000 in assets, currently financed entirely with equity. Equity is worth $6 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 Pessimistic Optimistic

Probability of state 0.44 0.56

Expected EBIT in state $ 4.90 million $ 18.90 million

The firm is considering switching to a 25-percent-debt capital structure, and has determined that it would have to pay a 10 percent yield on perpetual debt in either event.

Break even EBIT mean the level at which Earnings per share remains unchanged.

Total Assets value of firm = $85,656,000

Stock price of company = $6

Number of share outstanding =Total Assets value of firm / Stock price of company

= $85,656,000 / $6

= 14,276,000

Number of share outstanding is 14,276,000.

EBIT are given in two different scenario, Pessimistic economy and optimistic economy. So expected EBIT is calculated below:

Expected EBIT of company = (44% × 4.90) + (56% × 18.90)

= $2.156 + $10.584

= $12.74

Expected EBIT of company is $12.74 million.

Again company wants to restructure its capital structure with 25% debt. So total value of debt issue is calculated below:

Total value of debt issue = $85,656,000 × 25%

= $21,414,000

Total value of debt issue is $21,414,000.

Annual yield on debt = 10%

Interest payment = $21,414,000 × 10%

= $2,141,400

Company use the proceeds from debt issue in repurchase of share.

So total number of share repurchase = $21,414,000 / $6

= 3,569,000

Total number of share repurchase is 3,569,000.

Total Number of share remains after repurchase = 14,276,000 – 3,569,000

= 10,707,000

Total number of shares remains after repurchase is 10,707,000.

Break Even EBIT is calculated below:

Earnings per share before issue of debt = earnings per share after issue of debt

EBIT / 14,276,000 = (EBIT – $2,141,400) / 10,707,000

EBIT × (10,707,000 / 14,276,000) = (EBIT – $2,141,400)

75% × EBIT = EBIT – $2,141,400

25% × EBIT = 2,141,400

EBIT = $8,565,600

Break Even EBIT is $8,565,600.