Question

19. Brooks Corporation is financed with $32 million of 9% debt and $68 million of common...

19. Brooks Corporation is financed with $32 million of 9% debt and $68 million of common equity. The firm has 1 million shares of common stock outstanding. Brooks needs to raise $25 million and is undecided between two possible plans for raising this capital:

Plan A: Equity financing. Under this plan, common stock will be sold at $62.50 per share.

Plan B: Debt financing. Under this plan, 11% coupon bonds will be sold. At what level of operating income (EBIT) will the firm be indifferent between the two plans? Assume a 21% marginal tax rate.

Use breakeven EBIT formula

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Answer #1

At Breakeven ,Earning per share under both alternatives are equal.It is calculated using the formula=Earning available to stockholders /number of shares outstanding:

Alternative 1 2
Interest

current outstanding

32*9%=2.88

current outstanding +new issue of debt

[32*9%]+[25*11%]

2.88+ 2.75

5.63
Number of shares outstanding

1 million shares (current outstanding) +[25million/62.5] new issue

1+ .40

1.4 million shares

 1 million shares
Alternative 1 2
EBIT EBIT EBIT
Less:Interest 2.88 5.63
EBT EBIT -2.88 EBIT-5.63
less:Tax

.21[EBIT-2.88]

.21EBIT - .6048

.21[EBIT-5.63]

.21EBIT -1.1823
Income after tax

[EBIT-2.88]-[.21EBIT-.6048]

EBIT -2.88 -.21EBIT +.6048

.79 EBIT - 2.2752

[EBIT-5.63]-[.21EBIT -1.1823]

EBIT -5.63 -.21EBIT +1.1823

.79EBIT - 4.4477
Number of shares outstanding 1.4 1

At breakeven ,earning per shares are equal

[.79ebit -2.2752 ]/1.4 = [.79ebit -4.4477]/1

.79EBIT -2.2752 = 1.4[.79EBIT -4.4477]

.79EBIT- 2.2752 = 1.106 EBIT - 6.22678

1.106EBIT -.79 EBIT = -2.2752 +6.22678

.316 EBIT = 3.95158

EBIT = 3.95158 /.316

            = $ 12.505 Million

Breakeven point EBIT = 12.505 Million or 12,505,000

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