AA Tours is comparing two capital structures to determine how to best finance it
ID: 2628927 • Letter: A
Question
AA Tours is comparing two capital structures to determine how to best finance its operations. The first option consists of all equity financing. The second option is based on a debt-equity ratio of 0.45. What should AA Tours do if its expected earnings before interest and taxes (EBIT) are less than the break-even level? Assume there are no taxes.
a.select the leverage option because the debt-equity ratio is less than 0.50
b.select the leverage option since the expected EBIT is less than the break-even level
c.select the unlevered option since the debt-equity ratio is less than 0.50
d.select the unlevered option since the expected EBIT is less than the break-even level
e.cannot be determined from the information provided
Explanation / Answer
Option-D is correct.
Unlevered option consists more of equity than debt, hence it is less risky. Whereas, a levered option consists more of debt than equity, which bears more risk. Since, the expected EBIT is less than the break-even level, going with an unlevered option (less riskier) would be better.
Therefore, select the unlevered option since the expected ETIT is less than the break-even level.