Question 16.1: The MPD Corporation has decided in favor of a capital restru...
The MPD Corporation has decided in favor of a capital restructuring. Currently, MPD uses no debt financing. Following the restructuring, 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 financial leverage will increase EPS, so this will tell us the minimum level for EBIT. Under the old capital structure, EPS is EBIT/200,000. Under the new capital structure, the interest expense will be $1 million × .09 = $90,000. Furthermore, with the $1 million proceeds, MPD will repurchase $1 million/$20 = 50,000 shares of stock, leaving 150,000 shares outstanding. EPS will 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)
= $360,000
Verify that, in either case, EPS is $1.80 when EBIT is $360,000. Management at MPD is apparently of the opinion that EPS will exceed $1.80.