GTB, Inc., has a 20 percent tax rate and has $85,416,000 in assets, currently fi

Question

GTB, Inc., has a 20 percent tax rate and has $85,416,000 in assets, currently financed entirely with equity. Equity is worth $6 per share, and book value of equity is equal to market value of equity. Also, let’s assume that the firm’s expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities as shown below:

The firm is considering switching to a 25-percent-debt capital structure, and has determined that it would have to pay a 12 percent yield on perpetual debt in either event.

   

What will be the break-even level of EBIT?

  State Pessimistic Optimistic   Probability of state 0.40 0.60   Expected EBIT in state $ 4.50 million $ 18.50 million

Explanation / Answer

Expected EBIT = (.4*4.5)+(.6*18.5) = $12.9 million

EBIT is not affected by capital structure. Hence EBIT is the unaffected EPS. The break even EBIT will be the same EBIT as above under different capital structure.

The Break Even EBIT = Current EPS should remain the same in different capital structure.

Therefore 0.725 = (EBIT-2562480)*(1-.2)/10677000

0.8EBIT-2049984 = 7740825

0.8EBIT = 7740825+2049984

0.8EBIT = 9790809

BreakEven EBIT = 12238511.25

$ in million Expected EBIT 12.9 tax at 20% 2.58 Current Earnings after tax 10.32 Number of equity shares (85416000/6) 14236000 Current EPS ($) 0.724922731 EBIT EPS 0.906153414 Revised calculation $ in million Total assets 85.416 25% of debt finance 21.354 Cost of debt 2.56248 Expected EBIT 12.9 Interest cost 2.56248 EBT 10.33752 Tax at 20% 2.067504 Earnings after tax 8.270016 Equity share value (85416000*75% 64062000 Number of equity shares (64062000/6) 10677000 EPS 0.774563641 EBIT EPS 1.208204552

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