Sand Key Development Company has a capital structure consisting of $20 million o
ID: 2657555 • Letter: S
Question
Sand Key Development Company has a capital structure consisting of $20 million of 10% debt and $30 million of common equity. The firm has 500,000 shares of common stock outstanding. Sand Key is planning a major expansion and will need to raise $15 million. The firm must decide whether to finance the expansion with debt or equity. If equity financing is selected, common stock will be sold at $75 per share. If debt financing is chosen, 8% coupon bonds will be sold. The firm's marginal tax rate is 34%. Determine the level of operating income at which Sand Key would be indifferent between debt financing and equity financing.
Sand Key Development Company estimates that it will generate an operating income of $7.25 million. Which financing option should Sand Key use?
Explanation / Answer
a) The indifferent level of operating income will be the one at which Earnings per share (EPS) under both the options is equal. Let the indifferent operating income be "P".
New no. of shares to be issued under equity option = $15,000,000 / $75 per share = 200,000
Total no. of shares under equity option = 700,000
Interest under equity option = 10% x $20,000,000 = $2,000,000
Interest under debt option = $2,000,000 + 8% x $15,000,000 = $3,200,000
No. of shares under debt option = exiting shares = 500,000
EPS under equity = EPS under debt
or, [ (Operating income - Interest) x (1 - tax rate) ] / No. of shares = [ (Operating income - interest) x (1 - tax rate) ] / No. of shares
or, [ (P - $2,000,000) x (1 - 0.34) ] / 700,000 = [ (P - $3,200,000) x (1 - 0.34) ] / 500,000
or, 0.66 P - $1,320,000 = [ 0.66 P - $2,112,000 ] x 1.4
or, 0.66 P - $1,320,000 = 0.924 - $2,956,800
or, 0.264 P = $1,636,800
or, P = $6,200,000
b) EPS under equity option = [ ($7,250,000 - $2,000,000) x (1 - 0.34) ] / 700,000 = $4.95
EPS under debt option = [ ($7,250,000 - $3,200,000) x (1 - 0.34) ] / 500,000 = $5.35
If the operating income is $7,250,000, then debt option should be used as it has the higher EPS.
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.