Can someone please help me with this problem by breaking it down into steps? I k
ID: 2797739 • Letter: C
Question
Can someone please help me with this problem by breaking it down into steps?
I know we are supposed to use the formula provided
Question 17 1 pts ns Sand Key Development Company has a capital structure consisting of $20 million of 10% debt and $30 million of common equity. The firm has 500,000 shares of common stock outstanding. Sand Ke and will need to raise $15 million. The firm must decide whether to finance the expansion with debt or equity. If equity financing is selected, common stock will be sold at $75 per share. If debt financing is chosen, 8% coupon bonds will be sold. The firm's marginal tax rate is 34%. Determine the level of operating income at which Sand Key would be indifferent between debt financing and equity financing. y is planning a major expansion EBIT - D(1-t)-P EPS = $5,150,000 $5,675,000 O $6,725,000 O $6,200,000 O$4,625,000Explanation / Answer
The indifference level is basically that level of operating income where the EPS under both debt and equity financing will be the same. We are now going to calculate that.
The formula calculation will be done in Millions
Let us consider EBIT as x
Let us set up the formula for EPS that would be if the debt financing option was chosen.
Here, there is no preference dividend.
Interest is 10% of $20m debt = $2m
EPS = (EBIT-Interest) * (1-tax rate)/No.of shares
New interest figure would be = $2m + (15m * 8%)
= $3.2m
No. of shares would not change
EPS = (x-3.2) * (1-0.34)/0.5
Now for the equity option
No. of equity shares = $15m/$75 = 200,000 + 500,000 = 700,000 or 0.7m
EPS = (x-2) * (1-0.34)/0.7
Now to arrive at the point where both these EPS are the same, we treat these formulae as equal
(x-3.2)*0.66/0.5 = (x-2)*0.66/0.7
0.7 * (x-3.2) * 0.66 = 0.5 * (x-2) * 0.66
The common factors of 0.66 on both sides cancel each other out and the rest of the formula will look like this
0.7x - 2.24 = 0.5x - 1
0.2x = 1.24
Therefore x = 6.2
By solving this equation, we get the EBIT as $6.2m or $6,200,000