Here’s is a difficult one for you. I can’t solve question 15. These two questions are related. Firm Z expects its earnings before interest and taxes…

Here’s is a difficult one for you. I can’t solve question 15. These two questions are related.

14. Firm Z expects its earnings before interest and taxes (EBIT) to be €6,000 per year forever. The firm currently has no debt and its cost of equity is 18%. There are 10,000 shares outstanding. The firm is considering issuing bonds to add some financial leverage to the firm. The coupon rate on the bonds is 8%. Assuming a tax rate of 30%, what will the firm’s new cost of equity be after the restructuring if the firm issues €5,000 worth of bonds and uses the proceeds to repurchase shares?

a) 17.29%

b) 18.00%

c) 19.28%

d) 19.76%

I think here the answer is D 19,76%. Unleverd firm value = EBIT*(1-T)/Ru, thus Levered value = Vu + TD, after these Cost of equity is solveable from Re = Ru + (Ru + RD) * (D/E) giving an answer of 19,76%

15. Calculate the break-even EBIT for firm Z, i.e., the level of earnings before interest and taxes for which the earnings per share is the same under the current and proposed capital structures.

a) €1,867

b) €2,233

c) €2,500

d) €2,999

Here is a similiar question with an answer if it helps:

The MPD Corporation has decided in favor of a capital restructuring. Currently, MPD uses no debt fi nancing. Following the restructuring, however, debt will be \$1 million. The interest rate on the debt will be 9 percent. MPD currently has 200,000 shares outstanding, and the price per share is \$20. If the restructuring is expected to increase EPS, what is the minimum level for EBIT that MPD’s management must be expecting? Ignore taxes in answering.

To answer, we calculate the break-even EBIT. At any EBIT above this, the increased fi nancial leverage will increase EPS, so this will tell us the minimum level for EBIT. Under the old capital structure, EPS is simply EBIT / 200,000. Under the new capital structure, the interest expense will be \$1 million * 0.09 = \$90,000. Furthermore, with the \$1 million proceeds, MPD will repurchase \$1 milliony20 5 50,000 shares of stock, leaving 150,000 outstanding. EPS will thus be (EBIT – \$90,000)/150,000.

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

EBIT/ 200,000 = (EBIT – \$90,000) / 150,000

EBIT = 4/3 * (EBIT – \$90,000)

Break-Even EBIT = \$360,000

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