An all-equity financed firm has $500 in assets and the stock price is $20.If the firm restructures with 15 percent debt which creates interest expense of $30 per year and the firm's tax rate is 40 percent,what is the break-even EBIT?

Question

Quizplus · Accepted Answer

Before restructuring, the firm is all-equity financed, so its EBIT equals its net income. The firm's stock price and number of shares outstanding are irrelevant, as the firm's value is determined by its assets. Thus, the firm's initial EBIT is:

EBIT = Net Income
     = Assets - Interest Expense
     = $500 - 0
     = $500

After restructuring, the firm's interest expense is $30 per year, so its EBIT is:

EBIT = Net Income + Interest Expense
     = Assets(1 - Tax Rate) - Interest Expense
     = $500(1 - 0.4) - $30
     = $270

To find the break-even EBIT, we set the initial EBIT equal to the EBIT after restructuring:

$500 = $270

Next, we solve for the new EBIT that results in a net income of zero:

0 = $270 - 0.15(EBIT - $30)(1 - 0.4)
EBIT = $200

Thus, the break-even EBIT is $200.

An All-Equity Financed Firm Has $500 in Assets and the Stock