Question

A firm is analyzing the pros and cons of two different capital structures. The first option is an all-equity firm with 45,000 shares of stock. The second option is comprised of 30,000 shares of stock plus some debt. Ignoring taxes, the break-even level of earnings before interest and taxes between these two options is $32,000. How much money is the firm considering borrowing if the interest rate is 7 percent?

Answer 1

Break - even level of earnings before interest and taxes (EBIT) is the level at which Earnings per share (EPS) would be equal under both the options.

Earnings per share in case of all - equity = [EBIT - Interest] / no. of shares = [$32000 - $0] / 45000 = $0.7111111111

Earnings per share in case of all - equity = Earnings per share in case of debt

or, $0.7111111111 = [ $32000 - Interest ] / 30000

or, $32000 - Interest = $21333.3333333

or, Interest = $10,666.666666667

Level of debt = Interest / rate of interest = $10,666.666666667 / 7% = $152,380.952381 or $152,380.95