Question

Kelso Electric is an all-equity firm with 41,750 shares of stock outstanding. The company is considering the issue of $285,000 in debt at an interest rate of 7 percent and using the proceeds to repurchase stock. Under the new capital structure, there would be 25,500 shares of stock outstanding. Ignore taxes. What is the break-even EBIT between the two plans?

Answer 1

Let Breakeven EBIT be $x

Plan I:

Number of shares = 41,750

EPS = (EBIT - Interest Expense) / Number of shares
EPS = ($x - $0) / 41,750
EPS = $x / 41,750

Plan II:

Value of Debt = $285,000

Interest Expense = Interest Rate * Value of Debt
Interest Expense = 7% * $285,000
Interest Expense = $19,950

Number of shares = 25,500

EPS = (EBIT - Interest Expense) / Number of shares
EPS = ($x - $19,950) / 25,500

EPS under Plan I = EPS under Plan II
$x / 41,750 = ($x - $19,950) / 25,500
$x * 102 = $x * 167 - $19,950 * 167
$x * 102 = $x * 167 - $3,331,650
$x * 65 = $3,331,650
$x = $51,256

So, breakeven EBIT between two plans is $51,256