Crown Data(CD) has a current capital structure that consists of $120 million in common equity (15 million shares) and $80 million in long-term debt with an average interest rate of 11%. CD is considering an expansion project that will cost $22 million. The project will be financed either by issuing long-term debt at a cost of 12.5%, or the sale of new common stock at $35 per share. The firm's marginal tax rate is 40%. What is the EBIT indifference point between the two financing options?
A) $71.5 million
B) $77.2 million
C) $68.3 million
D) $1.0 million

Question

Quizplus · Accepted Answer

To find the EBIT indifference point, we need to set the cost of debt financing equal to the cost of equity financing. This can be done with the following formula:

($22 million)(0.125) = EBIT - ($15 million)(D/E)(0.11)(1 - 0.4)
where D/E represents the debt-to-equity ratio after the financing option is chosen.

If CD issues new common stock, the debt-to-equity ratio will remain the same, so we can solve for the EBIT indifference point:

($22 million)(0.125) = EBIT - ($15 million)($80 million/ $120 million)(0.11)(0.6)
EBIT = $77.2 million

If CD issues long-term debt, the debt-to-equity ratio will change, so we need to solve for the new debt-to-equity ratio and use that in the formula:

($22 million)(0.125) = EBIT - ($120 million + $22 million)(D/E)/(1 + D/E)(0.11)(0.6)
Solving for D/E yields 0.366, so the debt would be $102.96 million and the equity would be $97.04 million. Using these values in the formula gives:

($22 million)(0.125) = EBIT - ($102.96 million/$97.04 million)(0.11)(0.6)
EBIT = $71.5 million

Comparing these results shows that issuing new common stock is the better option, as the EBIT indifference point is higher.

Crown Data(CD) Has a Current Capital Structure That Consists of $120