Ettalong Electrical Company Ltd has 9000 shares outstanding and no debt.The new CFO is considering issuing $80 000 of debt and using the proceeds to retire 1500 shares.The coupon rate on the debt is 7.5 per cent.What is the break-even level of earnings before interest and taxes between these two capital structure options if the tax rate is 30 per cent?

Question

Quizplus · Accepted Answer

First, we need to find the earnings before interest and taxes (EBIT) at which the two capital structure options have equal earnings per share (EPS):

Option 1: 9000 shares outstanding, no debt

Option 2: 7500 shares outstanding (9000-1500), $80,000 of debt at 7.5% coupon rate, 30% tax rate

Let's assume EBIT = X.

Option 1 earnings per share (EPS1):
EPS1 = (X - 0.3X)/9000 = 0.7X/9000

Option 2 earnings per share (EPS2):
First, let's calculate the interest expense: 
Interest expense = $80,000 x 7.5% = $6,000
Tax shield on interest expense = $6,000 x 0.3 = $1,800
Net interest expense = $6,000 - $1,800 = $4,200
EPS2 = (X - 0.3X - $4,200)/7500 = (0.7X - $4,200)/7500

Now we need to find the EBIT at which EPS1 = EPS2:
0.7X/9000 = (0.7X - $4,200)/7500
Solving for X, we get X = $36,000

Therefore, the break-even level of EBIT is $36,000. At EBIT levels below $36,000, option 1 (no debt) is better because it has a higher EPS than option 2. At EBIT levels above $36,000, option 2 (with debt) is better because it has a higher EPS than option 1.

Since the break-even level of EBIT is higher than the current EBIT level is unknown, it is unclear whether option 2 is the best choice. Additionally, issuing debt comes with additional costs and risks such as interest payments and default risk. Therefore, whether or not to issue debt should be carefully evaluated by the CFO before making a decision.

Ettalong Electrical Company Ltd Has 9000 Shares Outstanding and No