Sulzar's capital structure consists only of common stock (20 million shares), but the firm is planning a major expansion, which will require $100 million of new capital. Sulzar has a choice of obtaining the needed capital through the sale of 5 million shares of common stock at $20 per share or the sale of $100 million of first mortgage bonds that would have a coupon rate of 9%. Assuming Sulzar has a marginal tax rate of 40%, calculate the EBIT-EPS indifference point.
A) $45 million
B) $36 million
C) $5 million
D) $9 million

Question

Quizplus · Accepted Answer

The EBIT-EPS indifference point is the level of EBIT at which the EPS is the same whether the firm uses debt or equity financing. To calculate the indifference point, we need to find the EBIT level at which the EPS from debt financing is equal to the EPS from equity financing.EPS from debt financing = (EBIT - Interest expense) x (1 - Tax rate) / Number of shares outstandingEPS from equity financing = EBIT x (1 - Tax rate) / Number of shares outstandingSetting the two EPS equations equal to each other, we get:(EBIT - Interest expense) x (1 - Tax rate) / Number of shares outstanding = EBIT x (1 - Tax rate) / Number of shares outstandingSolving for EBIT, we get:EBIT = Interest expense / (1 - Tax rate)In this case, the interest expense is $100 million x 9% = $9 million. The tax rate is 40%. So, the EBIT-EPS indifference point is:EBIT = $9 million / (1 - 0.40) = $15 million

Sulzar's Capital Structure Consists Only of Common Stock (20 Million