1) Sand Key Development Company has a capital structure consisting of $20 millio
ID: 2797358 • Letter: 1
Question
1) 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, 6% 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.
$6,200,000
$4,625,000
$5,150,000
$6,725,000
$5,675,000
2) Sand Key Development Company estimates that it will generate an operating income of $7.25 million. Which financing option should Sand Key use?
The equity financing option.
The debt financing option.
The firm should abandon plans for expansion.
Sand Key is indifferent between the two options.
We don't have enough information to answer this.
Explanation / Answer
Part 1:- Before Investment
10% Debt = 200,00,000 ; share Capital :- 300,00,000
New Investment Required = 150,00,000
if issued from Share Capital at $75/- per share no. of share capital = 150,00,000/75 = 200000 share
If issued from debt @ 6% = 150,00,000
For Calulation of indifference point income (profit after Tax ) should be equally at both the cases debt and share capital so, operating income is assumed = X
(EBIT - debt interest)(1-tax)/(500,000 + 2,00,000) = (EBIT - debt interest)(1-tax)/5,00,000
(X- 200,00,000*.1)(1-.34)/700,000 = (X- 200,00,000*.1 - 150,00,000*.06)(1-.34)/500,000
(x-20,00,000).66/7,00,000 = (x-20,00,000 - 9,00,000).66/500000
(.66X - 13,20,000)/7 = (.66X - 19,14,000)/ 5
5(.66x- 13,20,000) = 7(.66X - 19,14,000)
3.3X - 66,00,000 = 4.62 X - 13,398,000
4.62X - 3.3X = 13,398,000 - 66,00,000
1.32 X = 6,798,000
x = 5150,000
Part 2
If Operating Income is = 7.25 million or 72,50,000
If Equity Option opt then profit after Tax
Operating Income = 72,50,000
Less: interest = 20,00,000
(20million*.1)
EBT = 52,50,000
Less: tax (.34) =17,85,000
EAT = 34,65,000
No. of share = 700,000
after new investment
Per share earning = 4.95
If Debt option opt :
Total intrest taking from part 1 = 29,00,000
EBIt = 72,50,000
Less: interest = 29,00,000
EBT = 43,50,000
less :Tax = 14,79,000
EAT = 28,71,000
no. of share = 500000
earning per share = 5.742
Conclusion:- Issue of debt is best because earing per share is more in debt issue as compared to equity
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