Midwest Can Company is considering opening a new plant in St. Louis that is expected to produce an average EBIT of $3 million per year. To finance this new plant, Midwest is considering two financing plans. The first plan is to sell 600,000 shares of common stock at $15 each. The second plan is to sell 200,000 shares of common stock at $15 each and $6 million of 13% long-term debt. Assuming Midwest has a marginal tax rate of 40%, what is the EBIT-EPS indifference point for this plant?
A) $702,000
B) $234,000
C) $2,234,000
D) $1,170,000

Question

Quizplus · Accepted Answer

The EBIT-EPS indifference point is where the earnings per share (EPS) under both financing options are equal. To find this point, we calculate the EPS for both options and set them equal to each other. For the all-equity option (Option 1), the EPS is calculated as (EBIT - Taxes) / Total shares. Taxes are 40% of EBIT, so Tax = 0.4 * EBIT. Therefore, EPS = (EBIT - 0.4EBIT) / 600,000.For the mixed financing option (Option 2), the EPS is calculated as (EBIT - Interest - Taxes) / Total shares. Interest on the debt is 13% of $6 million, which equals $780,000. Taxes are 40% of (EBIT - Interest), so Tax = 0.4 * (EBIT - 780,000). Therefore, EPS = (EBIT - 780,000 - 0.4(EBIT - 780,000)) / 200,000.Setting the two EPS calculations equal to each other and solving for EBIT gives the EBIT-EPS indifference point. The calculation simplifies to an EBIT of $1,170,000.

Midwest Can Company Is Considering Opening a New Plant in St