High Sky, Inc., a hot-air balloon manufacturing firm, currently has the followin
ID: 2771442 • 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
The point of indifference can be calculated using the following formula:
((X-I1)(1-T) - PD)/S1 =((X-I2)(1-T) - PD)/S2
Where:
X = EBIT indifference level
I1 = Fixed interest costs under alternative 1.
I2 = Fixed interest costs under alternative 2.
PD = Preference dividend, if any.
T = Tax rate
S1 = Number of equity shares outstanding under alternative 1.
S2 = Number of equity shares outstanding under alternative 2.
T=0.4
I1=0
I2=66,000
S1=250,000
S2=100,000
Using the formula and the given values we find X to be equal to equal to 110,000.
Now if EBIT is greater than indifference value it is preferred to go for the debt alternative.
Z=(240,000-110,000)/50,000 = 2.6
Using the normal distribution tables we get that the probability that the debt alternative will produce higher profits is 99.53%
C) More information is needed
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.