Olde Towne 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

The break-even EBIT is where the earnings per share (EPS) are the same for both capital structures. For the all-equity option, EPS = EBIT / 40,000. For the debt-equity option, EPS = (EBIT - $24,000) / 25,000, where $24,000 is the interest on the debt ($300,000 * 8%). Setting these equal gives EBIT / 40,000 = (EBIT - 24,000) / 25,000. Solving for EBIT gives $64,000.

Olde Towne Industries Is Considering Both an All Equity and a Debt-Equity