Your company doesn't face any taxes and has $200 million in assets, currently financed entirely with equity. Equity is worth $10 per share, and book value of equity is equal to market value of equity. Also, let's assume that the firm's expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities shown as follows:
The firm is considering switching to a 40 percent debt capital structure, and has determined that they would have to pay an 8 percent yield on perpetual debt in either event. What will be the break-even EBIT?

Question

Your company doesn't face any taxes and has $200 million in assets, currently financed entirely with equity. Equity is worth $10 per share, and book value of equity is equal to market value of equity. Also, let's assume that the firm's expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities shown as follows: 
The firm is considering switching to a 40 percent debt capital structure, and has determined that they would have to pay an 8 percent yield on perpetual debt in either event. What will be the break-even EBIT?

Quizplus · Accepted Answer

To find the break-even EBIT, we need to find the EBIT level that makes the EPS the same under both financing options. The EPS can be calculated as follows:

EPS under all equity financing = (EBIT - Taxes) / # of shares outstanding
EPS under 40% debt financing = (EBIT - Interest Expense - Taxes) / # of shares outstanding

Setting these two EPS equations equal to each other, we can solve for the break-even EBIT:

(EBIT - Taxes) / # of shares outstanding = (EBIT - Interest Expense - Taxes) / # of shares outstanding
EBIT - Taxes = EBIT - Interest Expense - Taxes
Interest Expense = EBIT x Debt %
0.08 x D = EBIT x 0.4
D = EBIT x 5.

Plugging in the possible EBIT values and solving for D gives us the following:

- For EBIT = $10 million, D = $50 million
- For EBIT = $15 million, D = $75 million
- For EBIT = $20 million, D = $100 million

Since the assets are worth $200 million, the maximum amount of debt the company can take on is $80 million (40% x $200 million). Therefore, if the break-even EBIT requires a debt level greater than $80 million, the company will not be able to achieve it and should stick with 100% equity financing.

Based on our calculations, the break-even EBIT is $16 million (D = $80 million). Therefore, the answer is C.

Your Company Doesn't Face Any Taxes and Has $200 Million