Dagger Company has a current capital structure consisting of $60 million in long-term debt with an interest rate of 9% and $60 million in common equity (12 million shares). The firm is considering an expansion plan costing $23 million. The expansion plan can be financed with additional long-term debt at a 12% interest rate or the sale of new common stock at $8 per share. The firm's marginal tax rate is 40%. Determine the indifference level of EBIT for the two financing plans.
A) -$30.24 million
B) $18.36 million
C) $30.24 million
D) $19.68 million

Question

Quizplus · Accepted Answer

The indifference level of EBIT is where the EPS (Earnings Per Share) is the same for both financing options. To find this, we calculate the EBIT where the interest saved on debt (after taxes) equals the earnings dilution from issuing new shares.1. Calculate interest expense for both options:   - Existing debt: $60M * 9% = $5.4M   - New debt: $23M * 12% = $2.76M   - Total interest with new debt: $5.4M + $2.76M = $8.16M2. Calculate the number of new shares to be issued:   - $23M / $8 per share = 2.875M shares3. Calculate EPS for both options at a certain EBIT level, setting them equal to find the indifference point. The formula for EPS under each option is:   - With debt: $EPS_D = \frac{EBIT - Interest}{Total\ Shares}$   - With equity: $EPS_E = \frac{EBIT}{Total\ Shares + New\ Shares}$Given the tax rate (T) of 40%, the interest expense saved by taking on new debt is taxed, so the actual savings are $Interest \times (1 - T)$.Setting the EPS equations equal and solving for EBIT gives us the indifference level. The calculation involves algebraic manipulation to isolate EBIT. Given the complexity of the algebra, the key step is recognizing that at the indifference level of EBIT, the after-tax earnings available to shareholders are the same under both financing options.The correct answer, without going through all the algebra here, is found by applying the formula for the indifference level of EBIT considering the tax shield of debt and the dilution effect of issuing new equity. The calculation involves finding the EBIT level where the cost of new debt (after tax) equals the earnings dilution from new equity issuance.The correct answer is D) $19.68 million, which is the EBIT level at which the company would be indifferent between financing the expansion with debt or equity, considering the cost of debt and the dilution effect of issuing new shares.

Dagger Company Has a Current Capital Structure Consisting of $60