Question
iJigSaw is a small unlisted tech company that produces smartphone apps. Its capital comprises $20 million in ordinary shares and $5 million in long-term debt.
iJigSaw is a small unlisted tech company that produces smartphone apps. Its capital comprises $20 million in ordinary shares and $5 million in long-term debt. There are currently 1,000 shares outstanding and the interest rate on the debt is 5% per annum. Following a review of iJigSaw's capital structure, the company's newly appointed CFO has recommended that its debt-to-equity ratio should be increased to 40%, from its current level of 20%, in order to take better advantage of the tax-deductibility of interest payments. This would involve issuing $5 million in additional debt, which would be used to repurchase $5 million of the rm's equity. iJigSaw's investment bank has advised that the new debt would cost the rm 6% per annum in interest payments, but the shares could be repurchased at their current value.
(a) What is the breakeven EBIT where the proposed new capital structure delivers the same EPS as iJigSaw's existing capital structure?
(b) Should iJigSaw adopt the proposed new capital structure if its EBIT is $1.5 million?
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