Pierce Corp. is looking at two possible capital structures. Currently, the firm is an all-equity firm with $1.2 million dollars in assets and 200,000 shares outstanding
The market value of each stock is $6.00. The CEO of Pierce is thinking of leveraging the firm by selling $600,000 of debt financing. The cost of debt is 8% annually, and the current corporate tax rate for Pierce is 30%. What is the break-even EBIT for Pierce with these two possible capital structures?
What will be an ideal response?
Answer: Set the EPS of the two capital structures equal to each other and solve for EBIT.
The first step is to find the annual interest expense: Annual Interest Payment for Debt = $600,000 × 0.08 = $48,000.
The second step is to determine the number of shares that will be retired with the $600,000 raised through the sale of debt. Shares retired equal the debt funding divided by the current share price, $600,000 / $6.00 = 100,000.
The third step is to set the earnings per share of the two capital structures equal to each other. Earnings per share for the all-equity capital structure are the EBIT - Taxes divided by the number of shares outstanding: EPS all-equity firm = EBIT × (1 - 0.30) / 200,000.
Earnings per share for the leveraged capital structure are (EBIT - Interest - Taxes) / shares outstanding: EPS leveraged firm = [(EBIT - $48,000) × (1 - 0.30)] / 100,000.
Setting the two EPS equations equal and solving for EBIT we have, EBIT × (1 - 0.30) / 200,000 = [(EBIT - $48,000) × (1 - 0.30)] / 100,000. Solving for EBIT we find: (EBIT × 0.70) × 100,000 = [(EBIT × 0.70) - $33,600] × 200,000; EBIT × 0.70 = [(EBIT × 0.70) - $33,600] × 2; EBIT × 0.70 = 2 × (EBIT × 0.70) - $67,200; EBIT × 0.70 = $67,200; EBIT = $67,200 / 0.70 = $96,000 as the break-even EBIT.
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