Question

# Kelso Electric is an all-equity firm with 41,750 shares of stock outstanding. The company is considering...

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?

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

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