High Sky, Inc., a hot-air balloon manufacturing firm, currently has the followin
ID: 2771441 • Letter: H
Question
High Sky, Inc., a hot-air balloon manufacturing firm, currently has the following simplified balance sheet:
Assets
Liabilities and Capital
Total Assets
$ 1,100,000
Bonds (10% interest)
$ 600,000
Common Stock at par ($3), 100,000
shares outstanding
$ 300,000
Contributed capital in excess of par
$ 100,000
Retained earnings
$ 100,000
Total libalities and capital
$ 1,100,000
The company is planning an expansion that is expected to cost $600,000. The expansion can be financed with new equity (sold to net the company $4 per share) or with the sale of new bonds at an interest rate of 11 percent. (The firms marginal tax rate is 40 percent.)
A) Compute the indifference point between the two financing alternatives.
B) If the expected level of EBIT for the firm is $240,000 with a standard deviation of $50,000, what is the probability that the debt financing alternatives will produce higher earnings than the equity alternative? (EBIT is normally distributed.
C) If the debt alternative is chosen, what is the probability that the company will have negative earnings per share in any period?
Assets
Liabilities and Capital
Total Assets
$ 1,100,000
Bonds (10% interest)
$ 600,000
Common Stock at par ($3), 100,000
shares outstanding
$ 300,000
Contributed capital in excess of par
$ 100,000
Retained earnings
$ 100,000
Total libalities and capital
$ 1,100,000
Explanation / Answer
Cost of expansion =$600,000.
Interest rate on the new bonds=11%.
Interest rate on the old bonds=10%
Interest on the old bonds=$600,000 *10%
=$60,000.
Answer for question no:A:
Let x be the Earnings before interest.
In case the additional capital is raised in the form of Bonds, then interest payment =$600,000 *11%
=$66,000.
Total interest cost=$66,000+$60,000
=$126,000.
Earnings before tax= x - $126,000.
Tax = 40%(x-$126,000)
=.4x -$50,400
Earnings after tax=x-$126,000-(0.4x-$50,400)
=0.6x -$126,000 +$50,400
=0.6x-$75,600
Number of shares =100,000
Earnings per share =(0.6x-$75,600)/100,000 ---------------(1).
In case the funds are raised by way of equity:
Let x Earnings before interest.
Number of additional shares issued =$600,000/$4.
=150,000 shares.
Then Earnings after interet and before tax=x -$60,000.
Tax=0.40(x-$60,000)
Earnings after tax=x-$60,000 - (0.4x -24,000)
=0.6x -$60,000+$24,000
=0.6x -$36,000.
Total number of shares =100,000+150,000
=250,000
Earnings per share=(0.6x -$36,000)/250,000 ----------------------(2)
Inorder to be indifferent between the two financing options
(1) = (2)
(0.6x-$75,600)/100,000 = (0.6x -$36,000)/250,000
250,000/100,000(0.6x-$75,600) = (0.6x -$36,000)
2.5(0.6x-$75,600) = 0.6x -$36,000
1.5x - $189,000=0.6x -$36,000
0.9x =$189,000 -$36,000
0.9x =$153,000
x=$170,000.
Therefore, earnings before interest interest and tax at which both the options are indifferent is $170,000.
Answer for question no.B:
General rule is that if the earnings are below the indiffernce point then equity financing is more beneficial and where as when earnings are more than the indifference point, then earnings are more with debt financing.
So, to find the probability of debt financing more profitable than equity financing,
expected level of EBIT =$240,000
Standard deviation of operating earnings =$50,000
Indifference point between the two types of financing as computed in A above =$170,000
Formula for calculation of probability of a normal distributed data is as follows:
z= $170,000-$240,000/$50,000
=-1.4
Using normal distribution tables probability of earnings more returns in debt financing than equity at an EBIT level of $240,000 with a standard deviation of $50,000 is .08076 *100=8.076%
Answer for question no.C:
The company will incur loss if the company is not able to earn EBIT which is atleast equal to Interest obligation. As the company has opted debt financing, it should at least have EBIT which is equal to or more than interest obligation which is $126,000 as computed in A above.
To find probability of having negative EPS is $126,000 - $240,000/$50,000
=-2.28.
Using normal distribution tables probability of earnings a negative eps is 0.0110 *100 =1.1%
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