Question

GTB, Inc., has a 20 percent tax rate and has $85,776,000 in assets, currently financed entirely with equity. Equity is worth $6 per share, and book value of equity is equal to market value of equity. Also, let’s assume that the firm’s expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities as shown below: State Pessimistic Optimistic Probability of state 0.47 0.53 Expected EBIT in state $ 5.20 million $ 19.20 million The firm is considering switching to a 25-percent-debt capital structure, and has determined that it would have to pay a 10 percent yield on perpetual debt in either event. What will be the break-even level of EBIT?

Answer 1

Solution:

Break even EBIT means EPS under both situtaion is same:

No. of shares outstanding=Total value of Equity(i.e Total value of firm)/Price per share

=$85,776,000/$6

=14,296,000

Expected EBIT=Probabilty*EBIT

=0.47*5200,000+0.53*19200,000

=$12,620,000

Now company want to rstructure its capital structure through issue of 25% debt.Value of debt is;

=$85,776,000*25%=$21444,000

Interest on debt=$21444,000*10%=$2,144,400

Debt issue will utilize to repurchase shares,thus no. of shares repurchase is;

=Value of debt/Market price per share

=$21444,000/6

=3,574,000

No. of shares left after repurchase=14,296,000-3,574,000

=10,722,000

Now,Break even EBIT is calculated as follow

EPS before capital restructure=EPS after restructure

EBIT/14,296,000=(EBIT-$2,144,400)/10,722,000

EBIT*0.75=EBIT-$2,144,400

EBIT-0.75EBIT=$2,144,400

EBIT=$2,144,400/0.25

=$8,577,600