Beijing Berings is considering purchasing a small firm in the same line of busin

Question

Beijing Berings is considering purchasing a small firm in the same line of business. The purchase would be financed by the sale of common stock or a bond issue. The financial manager needs to evaluate how the two alternative financing plans will affect the earnings potential of the firm. Total financing required is $4.5 million. The firm currently has $20,000,000 of 12 percent bonds and 600,000 common shares outstanding. The firm can arrange financing of the $4.5 million through a 14 percent bond issue or the sale of 100,000 shares of common stock. The firm has a 40 percent tax rate.

(a) What is the degree of financial leverage for each plan at $7,000,000 of EBIT?

(b) What is the financial breakeven point for each plan?

Explanation / Answer

Answer:

a. Degree of financial leverage (DFL) = EBIT / (EBIT-Interest)

For Debt plan:

EBIT = $7,000,000

Interest = ($20,000,000 *12% ) + ($4,500,000*14%) = $3,030,000

Hence DFL = $7,000,000 / ($7,000,000 - $3,030,000)

= $7,000,000 / $3970000

= 1.76

For Equity plan:

EBIT = $7,000,000

Interest = ($20,000,000 *12% ) = $2,400,000

Hence DFL = $7,000,000 / ($7,000,000 - $2,400,000)

= $7,000,000 / $4600000

= 1.52

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