GTB, Inc., has a 25 percent tax rate and has a $85,536,000 in assets, currently

Question

GTB, Inc., has a 25 percent tax rate and has a $85,536,000 in assets, currently financed entirely with equity. Equity is worth $6 per share, and book value of equity is equal to market value of equity. Also, let's assume that the firm's expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities as shown below:

State Pessimistic Optimistic

Probabilities of State 0.42 0.58

Expected EBIT in state $4.70 million $18.70 million

The firm is considering switching to a 25-percent-debt capital structure, and has determined that it would have to pay a 9 percent yield on perpetual debt in either event.

What will be the break-even level of EBIT?

EBIT $____________

Explanation / Answer

The condition for break even EBIT is that EPS remains constant.

Now, No. of outstanding shares = $85,536,000 / $6

= 14,256,000

Expected EBIT = 0.42 * $4.70mn + 0.58 * 18.70mn

= $12.82 mn or $12,820,000

Therefore, PAT = EBIT * (1 - tax rate).............[since no interest]

= $12,820,000 * (1 - 25%)

= $9,615,000

Therefore, EPS = $9,615,000 / 14,256,000

= $0.68

Now, with 25% debt capital structure, the no. of equity comes down to $64,152,000 (=75% * $85,536,000).

As such, no of outstanding shares = $64,152,000 / $6

= 10,692,000

Now, Interest expense = 25% * $85,536,000 * 9%

= $1,924,560

Now, to maintain EPS the break even level of EBIT = Outstanding no. of shares * EPS / (1 - tax rate) + Interest expense

= 10,692,000 * $0.68 / (1 - 25%) + $1,924,560

= $11,618,640 or $11.62mn is the EBIT at break even

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