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, 7% 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

Answer 1

The level of operating income at which Sand Key would be indifferent between debt financing and equity financing is: $5,675,000.

Indifferent between debt financing and equity financing

First step

Number of new shares to be issued = 15,000,000/75

Number of new shares to be issued = 200,000 shares

Total number of shares if equity is issued =500,000+200,000

Total number of shares if equity is issued =700,000 shares

Second step

Total interest expense under Debt option=[(20,000,000×10%)+(15,000,000×7%)]

Total interest expense under Debt option=2,000,000+1,050,000

Total interest expense under Debt option=3,050,000

EPS under Equity option =(EBIT-2,000,000)×(1-0.34)/700,000

EPS under Equity option =(EBIT-2,000,000)×0.66/700,000

EPS under Debt option =(EBIT-3,050,000)×0.66/500,000

Third step

Indifference level operating income  (EBIT)

(EBIT-2,000,000)×0.66/700,000 = (EBIT-3,050,000)×0.66/500,000

Solve for EBIT:

5×(EBIT-2,000,000) = 7×(EBIT-3,050,000)

2×EBIT = 7×3,050,000-5×2,000,000

2×EBIT=21,350,000-10,000,000

2×EBIT=11,350,000

EBIT =11,350,000/2  

EBIT=$5,675,000

Therefore the level of operating income at which Sand Key would be indifferent between debt financing and equity financing is: $5,675,000.

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