An unlevered firm with a market value of $1 million has 50,000 shares outstanding. The firm restructures itself by issuing 200 new bonds with face value $1,000 and an 8% coupon. The firm uses the proceeds to repurchase outstanding stock. In considering the newly levered versus formerly unlevered firm, what is the break-even EBIT? Ignore taxes.
A) $25,000
B) $50,000
C) $75,000
D) $80,000
E) $95,000

Question

Quizplus · Accepted Answer

The break-even EBIT is the level of Earnings Before Interest and Taxes where the earnings per share (EPS) for the levered and unlevered firm are the same. To find this, we calculate the interest expense from the new debt and compare the earnings available to shareholders before and after the restructuring. The firm issues 200 bonds at $1,000 each, raising $200,000. The annual interest expense is 8% of $200,000, which is $16,000. For the unlevered firm, the entire EBIT goes to shareholders. For the levered firm, EBIT must first cover the interest expense. The break-even point is when EBIT - Interest = EBIT for the unlevered firm, which simplifies to just the interest expense since the unlevered firm has no interest expense. Therefore, the break-even EBIT is the interest expense of $16,000. However, none of the provided options match this calculation, indicating a potential misunderstanding in the setup or a mistake in the calculation process based on the provided options. Given the options, the closest approach to finding a break-even EBIT involves considering the cost of debt and the amount of debt issued, but without taxes and given the straightforward calculation, there seems to be a discrepancy in the provided answer choices or a misinterpretation of the question's requirements.

An Unlevered Firm with a Market Value of $1 Million