Question

Halifax Inc. is evaluating two financing options to raise $10 million for an expansion project. Halifax Inc. can borrow money from a bank and the interest rate will be 8%, or Halifax Inc. can issue one million common stocks for $10 per share.

The company currently has 2.5 million common shares.

Without the new financing, the projected income statement of Halifax Inc. is shown below.

The earnings per share for Halifax Inc. are: 1.03 under public issue and 1.95 under bank.

Determine the break-even EBIT between the two financing options.... given this, if Halifax Inc. expects an EBIT of $7.4 million in 2017, will it be beneficial to increase leverage?

Sales Revenue 30,253

Operating Expenses 14,740

Earnings from Resort Operations 15,513

Administration 2,719

Marketing/Promotion 941

Miscellaneous 302

Earnings before Interest, Depreciation & Amortization (EBITDA) 11,550

Depreciation 2,682

Amortization of Goodwill 324

Earnings before Interest & Taxes (EBIT) 8,543

Interest 2,718

Earnings before Taxes (EBT) 5,826

Taxes @ 38% .... 2214

Net Income 3,612

Dividends 1,047

Increase (Decrease) in Retained Earnings 2,564

Answer 1

Let E be the break EBIT, expressed in $ million.

Case 1: Borrow money from a bank and the interest rate will be 8%,

EPS₁ = (E - existing interest - incremental interest) x (1 - Tax rate) / Existing number of shares

= (E - 2.718 - 8% x 10) x (1 - 38%) / 2.5 = (E - 3.518) x 0.62 / 2.5

Case 2: issue one million common stocks for $10 per share.

EPS₂ = (E - existing interest) x (1 - Tax rate) / (Existing number of shares + new shares issued)

= (E - 2.718) x (1 - 38%) / (2.5 + 1) = (E - 2.718) x 0.62 / 3.5

EPS₁ = EPS₂

Hence, (E - 3.518) x 0.62 / 2.5 = (E - 2.718) x 0.62 / 3.5

Hence, 3.5 x (E - 3.518) = 2.5 x (E - 2.718)

Or, Break even EBIT = E = (3.5 x 3.518 - 2.5 x 2.718) / (3.5 - 2.5) = $ 5.518 million

-----------------------

Now if EBIT is $ 7.4 mn;

EPS₁ =  (E - 3.518) x 0.62 / 2.5 = (7.4 - 3.518) x 0.62 / 2.5 = $  0.9627 / share

EPS₂ = (E - 2.718) x 0.62 / 3.5 = (7.4 - 2.718) x 0.62 / 3.5 = $  0.8294 / share

Increasing leverage will help improve the EPS.

Hence, it be beneficial to increase leverage.