Question

Revolution Inc currently has $2,320,000 in 5% coupon bonds, and 75,000 common shares outstanding. The tax rate is 40%. They are planning a major program requiring $10,000,000 in financing. The company is considering two options to raise the funds:

Option 1) raise 40% by selling bonds at par with a 6% coupon rate and the remaining 60% with preferred shares sold at par with a 7% cash dividend.
Option 2) sell shares of common stock at $80 per share to get the needed funds.
What level of EBIT would yield the same EPS for the stock and debt alternatives (breakeven point or indifference point)?

Answer 1

The level of EBIT that would yield the same EPS for both stock and debt financing options (the breakeven point or indifference point) can be calculated by accounting for the costs and savings associated with each financing option and equating the resulting EPS calculations.

Step-by-step explanation:

The question asks for the calculation of the level of Earnings Before Interest and Taxes (EBIT) that would result in the same Earnings Per Share (EPS) under two different financing options for a company's required funding for a major program. In option 1, the company would raise part of the funds through selling bonds and the rest through preferred shares. In option 2, the company would sell additional common stock. To calculate the breakeven point or indifference point of EBIT for both options, one must first determine the interest expense for the new debt, dividend payments for preferred shares if any, the tax savings from interest expenses (due to the tax-deductibility of interest), and the total number of common shares outstanding if option 2 is chosen. Then, the EBIT at which the EPS resulting from these calculations is the same for both options must be found by setting up and solving an equation that reflects these details.