ABC, Inc. is comparing two capital structures to determine how to best finance the firm's operations. The first option consists of 100% equity financing. The second option is based on a debt-equity ratio of.40. What should ABC do if expected earnings before interest and taxes (EBIT) are less than the break-even level? Assume there are no taxes.
A) Select the leverage option because the debt-equity ratio is less than.50.
B) Select the leverage option since the expected EBIT is less than the break-even level.
C) Select the unlevered option since the debt-equity ratio is less than.50.
D) Select the unlevered option since the expected EBIT is less than the break-even level.
E) Cannot be determined from the information provided.

Question

Quizplus · Accepted Answer

When expected EBIT is less than the break-even level, it means the company might not generate enough revenue to cover its fixed costs, including interest on debt. In such a scenario, opting for an unlevered option (100% equity financing) is safer because it avoids the risk of not being able to meet interest obligations on debt.

ABC, Inc Is Comparing Two Capital Structures to Determine How to to Best