CFA Level ICorporate IssuersHard
Ferrington Ltd. is evaluating two financing plans to raise $5,000,000 in new capital. Plan A: issue 1,000,000 new common shares (all-equity). Plan B: issue $5,000,000 of debt at 8% interest, combined with issuing only 600,000 new common shares. The firm's marginal tax rate is 30%. At what level of EBIT are the earnings per share (EPS) under the two plans equal (the EBIT-EPS indifference point)?
- A$1,400,000
- B$400,000
- C$700,000
- D$1,000,000
Show answer & explanationAnswer & explanation
Correct answer: D. $1,000,000
Interest expense under Plan B = $5,000,000 × 8% = $400,000. Setting EPS equal: EBIT(1−t)/1,000,000 = (EBIT−400,000)(1−t)/600,000. The (1−t) terms cancel, giving 600,000×EBIT = 1,000,000×(EBIT−400,000), so 400,000×EBIT = 400,000,000,000, and EBIT = $1,000,000. At this EBIT, both plans produce EPS of $0.70 (verify: Plan A: 1,000,000×0.7/1,000,000=$0.70; Plan B: (1,000,000−400,000)×0.7/600,000=$0.70).
Why the other options are wrong
- A. Overstates the indifference point; produces unequal EPS between the two plans.
- B. This is just the interest expense, not the indifference EBIT.
- C. Does not satisfy the EPS-equality equation when checked against both plans.
EBIT-EPS Indifference Point
The level of EBIT at which two alternative financing plans produce identical earnings per share, used to evaluate the impact of financial leverage on EPS.
- Above the indifference EBIT, more leveraged plans produce higher EPS
- Below it, the less leveraged (equity-heavy) plan produces higher EPS
- Formula: (EBIT)(1-t)/N1 = (EBIT-I)(1-t)/N2
Memory trick: Find the tipping point where debt's extra risk finally pays off in EPS.