OldeTowne Industries is considering both an all equity and a debt-equity capital structure. The all equity capital structure would consist of 40,000 shares of stock. The debt and equity option would
Consist of 25,000 shares of stock plus $300,000 of debt at an interest rate of 8%. What is the
Break-even level of earnings before interest and taxes between these two options? Ignore taxes.
A) $52,000
B) $57,000
C) $64,000
D) $66,000
E) $74,000

Question

Quizplus · Accepted Answer

To find the break-even level of earnings before interest and taxes (EBIT), we need to find the point where the earnings are the same for both options.

For the all equity option, the earnings before taxes would simply be the number of shares (40,000) multiplied by the earnings per share (EPS):

EBIT(all equity) = 40,000 * EPS

For the debt-equity option, we need to take into account the interest expense from the debt:

EBIT(debt-equity) = (25,000 * EPS) - (0.08 * $300,000)

Setting these two equations equal to each other and solving for EPS:

40,000 * EPS = (25,000 * EPS) - (0.08 * $300,000)
15,000 * EPS = $24,000
EPS = $24,000 / 15,000
EPS = $1.60

Now that we have the EPS, we can find the break-even level of EBIT by plugging it into either equation:

EBIT(all equity) = 40,000 * $1.60 = $64,000
EBIT(debt-equity) = (25,000 * $1.60) - (0.08 * $300,000) = $64,000

So the break-even level of EBIT between these two options is $64,000.

The best choice depends on the goals and priorities of OldeTowne Industries. The all equity option would have lower financial risk since there is no debt to repay, but the debt-equity option would have a lower cost of capital since debt is generally less expensive than equity. If the company can effectively use the borrowed funds to generate higher returns than the cost of the debt, the debt-equity option may be more beneficial in the long run. However, if the company values stability and lower financial risk, the all equity option may be more attractive.

OldeTowne Industries Is Considering Both an All Equity and a Debt-Equity