I got this question and I am puzzled with the answer. Could please somebody help to understand where $27,000 EBIT came from? How was it calculated? Thank you!!!
A company currently has 1,000 shares of common stock outstanding with zero debt. It has the choice of raising an additional $100,000 by issuing 9% long-term debt, or issuing 500 shares of common stock. The company has a 40% tax rate. What level of earnings before interest and taxes (EBIT) would result in the same earnings per share (EPS) for the two financing options?
the answer is An EBIT of $27,000 would result in EPS of $10.80 for both. The requirement is to determine the level of earnings before interest and taxes that would result in the same earnings per share under the two financing options. This answer is correct as calculated below.
Alternative 1—issuing long-term debt
Interest = $9,000 ($100,000 × 9%)
Earnings = $18,000 ($27,000 EBIT – $9,000 interest)
before taxes (EBT)
Taxes = $7,200 (40% $18,000 EBT)
Net earnings = $10,800 ($18,000 EBT – $7,200 taxes)
EPS = $10.80 (net earnings $10,800 ÷ 1,000 shares outstanding)
Alternative 2—issue additional stock
Net earnings = $16,200 [$27,000 EBIT – taxes $10,800 (40% × $27,000)]
EPS = $10.80 (net earnings $16,200 ÷ 1,500 shares outstanding)
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