High Sky, Inc., a hot-air balloon manufacturing firm, currently has the following simplified balance sheet:
Assets
Liabilities and Capital
Total Assets
$ 1,100,000
Bonds (10% interest)
$ 600,000
Common Stock at par ($3), 100,000
shares outstanding
$ 300,000
Contributed capital in excess of par
$ 100,000
Retained earnings
$ 100,000
Total libalities and capital
$ 1,100,000
The company is planning an expansion that is expected to cost $600,000. The expansion can be financed with new equity (sold to net the company $4 per share) or with the sale of new bonds at an interest rate of 11 percent. (The firm's marginal tax rate is 40 percent.)
Compute the indifference point between the two financing alternatives.
If the expected level of EBIT for the firm is $240,000 with a standard deviation of $50,000, what is the probability that the debt financing alternatives will produce higher earnings than the equity alternative? (EBIT is normally distributed.)
If the debt alternative is chosen, what is the probability that the company will have negative earnings per share in any period?