Answers to Chapter Review and Self Test Problems

To answer, we can calculate the break-even EBIT. At any EBIT above this, the increased financial leverage will increase EPS. Under the old capital structure, the interest bill is $80 million X .09 = $7,200,000. There are 10 million shares of stock, so, ignoring taxes, EPS is (EBIT — $7.2 million)/10 million.

Under the new capital structure, the interest expense will be $125 million X .09 = $11.25 million. Furthermore, the debt rises by $45 million. This amount is sufficient to repurchase $45 million/$45 = 1 million shares of stock, leaving 9 million outstanding. EPS is thus (EBIT — $11.25 million)/9 million.

Now that we know how to calculate EPS under both scenarios, we set the two calculations equal to each other and solve for the break-even EBIT:

(EBIT - $7.2 million)/10 million EBIT - $7.2 million EBIT

(EBIT - $11.25 million)/9 million 1.11 X (EBIT - $11.25 million) $47,700,000

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