Question

Clover Foods is considering two different capital structures. The first option consists of​ 12,000 shares of stock. The second option consists of​ 8,000 shares of stock plus​ $125,000 of debt at an interest rate of 7 percent. Tax rate is​ 20%. What is the​ break-even level of earnings before interest and taxes​ (EBIT) between these two​ options?

A. ​$5,250

B. ​$21,000

C. ​$26,250

D. ​$17,500

E. ​$14,000

Answer 1

The break even level of EBIT is computed as shown below:

[ EBIT - (Debt Amount x Interest rate) ] / Number of shares outstanding in second option = EBIT / Number of shares outstanding in first option

[ EBIT - ($ 125,000 x 0.07) ] / 8,000 = EBIT / 12,000

12,000 x [ EBIT - ($ 125,000 x 0.07) ] = EBIT X 8,000

12,000 x [ EBIT - $ 8,750) ] = 8,000 EBIT

12,000 EBIT - $ 105,000,000 = 8,000 EBIT

4,000 EBIT = $ 105,000,000

EBIT = $ 26,250

So, the correct answer is option C.

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