Kelso Electric is debating between a leveraged and an unleveraged capital struct
ID: 2652793 • Letter: K
Question
Kelso Electric is debating between a leveraged and an unleveraged capital structure. The all equity capital structure would consist of 40,000 shares of stock. The debt and equity option would consist of 25,000 shares of stock plus $250,000 of debt with an annual interest rate of 6 percent. What is the break-even level of earnings before interest and taxes (EBIT) between these two options? Ignore taxes.
HINT: Remember that the break-even point here means the EBIT where the EPS is the same for the unlevered and levered company.
$1,242,208
$244,141
$846,333
$49,667
$40,000
Explanation / Answer
The relationship between EBIT and EPS is as follows:
(EBIT – I) (1-t)
EPS = ---------------------
n
Where,
EBIT = earnings before interest and taxes
EPS = earnings per share
I = interest
t = tax rate
n = number of equity shares
Break-even EBIT level
Break-even EBIT level is the indifferent point where EPS under alternative financing plan is the same. Mathematically, the break-even EBIT level is:
(EBIT* - I1) (1 – t) (EBIT* - I2) (1- t)
--------------------------- = -------------------------
n1 n2
Where,
EBIT* = indifference point between the two alternative financing plans
I1, I2 = interest expenses
t = income-tax rate
n1, n2 = number of equity shares outstanding after adopting financing plans 1and 2
Applying the above equation we get,
(EBIT* - 0) (EBIT* - 15000)
----------------------- = ------------------------------------
40000 25000
EBIT = $ 40000
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