GTB, Inc., has a 20 percent tax rate and has $85,416,000 in assets, currently fi
ID: 2753716 • Letter: G
Question
GTB, Inc., has a 20 percent tax rate and has $85,416,000 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:
The firm is considering switching to a 25-percent-debt capital structure, and has determined that it would have to pay a 12 percent yield on perpetual debt in either event.
What will be the break-even level of EBIT?
State Pessimistic Optimistic Probability of state 0.40 0.60 Expected EBIT in state $ 4.50 million $ 18.50 millionExplanation / Answer
Expected EBIT = 0.40 * 4.50 + 0.60 * 18.50 = 12.90
Number of shares = 85416000/6 = 14236000
EPS = 12.90 million / 14.236 million = 0.90615
When financed with 25% debt, Debt value = 25% of 85416000 = 21354000
Interest @ 12% = 2154000 * 0.12 = 2562480
New Investment of equity = 85416000 - 21354000 = 64062000
Number of shares to be issued = 64062000 / 6 = 10677000
Break Even EBIT = EPS required * New Shares + Debt Interest = 0.90615 * 10677000 + 2562480 = 12237444
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