Dippity Doodle Noodle Makers has a capital structure that consists of 2.0 million shares outstanding and $2.0 million of debt at 8% interest. The company is planning a major plant expansion and must decide between the following two financing plans. Option 1 is to increase debt by $1.0 million at 9% interest and sell 10,000 new shares of stock at $50 per share. Option 2 is to sell 30,000 new shares of stock at $50 per share. What would be the indifference point and, considering that EBIT is expected to be $10,000,000, which option would be best?
A) Indifference of $10,750,000; use stock option.
B) Indifference of $1,600,000; use stock option.
C) Indifference of $16,270,000; use the debt option.
D) Indifference of $9,250,000; use the debt option.

Question

Quizplus · Accepted Answer

To calculate the indifference point, we need to find the point at which both finance options have the same EPS, which can be calculated as:
EBIT – interest / number of shares
For Option 1:
EBIT –0.08($2,000,000+$1,000,000) / 2,010,000 = EPS
For Option 2:
EBIT –0.08($2,000,000) / 2,030,000 = EPS
Setting the two EPS equations equal to each other and solving for EBIT gives us an indifference point of $9,250,000.
Since the expected EBIT is $10,000,000, Option 1 would result in a higher EPS and therefore would be the better choice.

Dippity Doodle Noodle Makers Has a Capital Structure That Consists