Question

Atlantic Seafood has determined that $17,000 is the break-even level of earnings before interest and taxes for the two capital structures it is considering. The one structure consists of all equity with 12,000 shares of stock. The second structure consists of 9,000 shares of stock and $50,000 of debt. What is the interest rate on the debt?

Answer 1

Breakeven Level means that EPS will be the same.

Let's calculate the EPS for all equity with 12000 shares: $17,000 / 12000 =$1.416666/share (ie. Breakeven EBIT/No. of shares)

Now, EPS for second structure(consisting of 9000 shares and $50,000 debt) shall also be $1.416666/share (since we are at breakeven)

No. of shares are 9,000

Total Earnings for second structure after interest shall be 9,000 * 1.416666 = $12750 (EPS * No. of shares)

Amount of Interest shall be: Earnings Before Interest - Earnings After Interest

Amount of Interest shall be $17000 - $12750 ie. $4250

The interest rate on debt shall be (4250 / 50000)*100 ie. 8.5% [(Interest/Debt)*100]