Question

CGC Ltd. is planning to reduce debt through a $4 million equity issue. The existing $10m...

CGC Ltd. is planning to reduce debt through a $4 million equity issue. The existing $10m term loan has an interest rate of 6% p.a.

Shares outstanding are currently 200,000 with a share price of $100 each.

Market value of equity is $20m.

The company forecasts EBIT of $2m.

The company tax rate is 30%. Should CGC change its capital structure?

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Answer #1

One approach is to find the breakeven point:

[(EBIT 600,000)(1 30%)]/200,000 = [(EBIT 360,000)(1 30%)]/240,000

[EBIT 600,000]/5 = [EBIT 360,000]/6

6EBIT 3,600,000 = 5EBIT 1,800,000

EBIT = 1,800,000

A second method is to compare the EPS:

Current Proposed
EBIT 2,000,000 2,000,000
Interest 600,000 360,000
Profit Before Tax 1,400,000 1,640,000
Tax 420,000 492,000
Profit After Tax 980,000 1,148,000
Shares 200,000 240,000
EPS 4.90 4.78

Ultimately, either method shows that the company should not change its capital structure.

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