21. Kelso Electric is debating between a leveraged and an unleveraged capital st

Question

21. Kelso Electric is debating between a leveraged and an unleveraged capital structure. The all equity capital structure would consist of 900,000 shares of stock. The debt and equity option would consist of 300,000 shares of stock plus $4,000,000 of debt with an interest rate of 10 percent What is the break-even level of earnings before interest and taxes between these two options? Ignore taxes. a) b) What does the break-even EBIT measure? If all of your EBIT predictions for the company are above $1,000,000, what is your recommendation? c)

Explanation / Answer

a. Let the breakeven EBIT be "x"

Thus x/900,000 = [x - ($4,000,000*10%)]/300,000

or x/900,000 = (x - 400,000)/300,000

or x = 600,000

b. The break even EBIT measures the level of EBIT for which the EPS (earnings per share) is the same under both the financing plans i.e. in case of all equity plan and debt and equity plan.

c. Let us consider EPS for both the capital structures for a couple of EBITS above 1,000,000:

As we can see EPS is higher in cases of capital plan with both debt and equity. Thus Kelso should opt for the plan which has 300,000 shares and $4,000,000 worth of debt.

EBIT EPS under all equity plan EPS under debt and equity plan 11,000,000.00 12.22 35.33 11,500,000.00 12.78 37.00 12,000,000.00 13.33 38.67

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