ADA, Inc. currently has 20,000 shares of stock outstanding at a market value of $40 a share. The firm is currently 100% financed with equity. ADA is considering a restructuring which will include issuing $400,000 of bonds at par value with a coupon rate of 6%. What is the break-even EBIT?
A) $12,000
B) $24,000
C) $36,000
D) $48,000
E) $60,000

Question

Quizplus · Accepted Answer

The break-even EBIT is the level of Earnings Before Interest and Taxes where the earnings per share (EPS) are the same whether the company is financed with equity only or with a mix of debt and equity. To find the break-even EBIT, we compare the interest expense to the cost of equity financing.First, calculate the interest expense: $400,000 of bonds at a 6% coupon rate equals $24,000 in annual interest expense.Next, determine the equity value before restructuring: 20,000 shares at $40 each equals $800,000.The break-even EBIT will be when the cost of debt ($24,000) equals the earnings that would have been generated on the equity replaced by debt. Since the firm is initially all equity, the entire $400,000 of debt replaces equity. The break-even point is when the return on the replaced equity equals the interest expense.Given that the firm is 100% equity-financed initially, the break-even EBIT must be such that the earnings attributable to the $400,000 of equity (now replaced by debt) would have been equal to the $24,000 interest expense. This implies an EBIT where the firm is indifferent between financing methods, which occurs when the cost of debt financing equals the return on equity financing.Since the question does not provide a specific cost of equity or return rate for the equity, we infer that the break-even point directly relates to the interest expense, which is the firm's cost of debt. Therefore, the break-even EBIT is the point where the firm's earnings before interest and taxes equal its interest obligations, which is $24,000. However, this interpretation overlooks the need to cover both the interest expense and provide the same level of earnings to equity as before restructuring. The correct approach involves ensuring the total financing cost (interest plus the earnings equivalent to equity) remains constant, leading to a higher break-even EBIT than just the interest expense.To correctly calculate the break-even EBIT, we need to consider the earnings that would have been generated by the $400,000 of equity. Since the question does not provide a specific return rate for the equity, we cannot directly calculate this based on the information given. However, the correct approach to finding the break-even EBIT involves comparing the total costs (interest and equity returns) under both scenarios, which typically requires more information than provided.Given the options available and the typical approach to calculating break-even EBIT in a restructuring scenario, the correct answer involves understanding that the break-even EBIT is the level of earnings before interest and taxes where the firm is indifferent between using debt or equity. This typically involves calculations that account for the cost of debt (interest expense) and the return on equity. However, without specific details on the return on equity or additional financial metrics, the calculation simplifies to comparing scenarios based on the given interest expense and the implied cost of replacing equity with debt.Therefore, acknowledging the confusion and the typical methodology for calculating break-even EBIT, the correct answer is chosen based on the standard approach to these calculations in finance, which often involves detailed analysis beyond just the interest expense. The provided options and the correct methodology suggest a more complex calculation is intended, but with the given information, a precise calculation aligning with the options cannot be accurately completed without additional assumptions about the return on equity or the cost of equity.

ADA, Inc Currently Has 20,000 Shares of Stock Outstanding at a a Market