EBITDA, Inc., a subsidiary of Robinson Enterprises, is considering the purchase of a fleet of new BMWs for the CEO and other senior managers. Currently the firm has a capital structure that consists of 60 percent debt, 30 percent common equity, and 10 percent preferred stock.
The pretax interest rate on currently outstanding debt is 9 percent. The dividend yield on the company's preferred stock is 12 percent. Total capitalization is $20 million. This fleet of new cars will cost $1,000,000 and the company plans to finance the entire purchase with debt at a pretax interest rate of 10 percent.
The firm's marginal tax rate is 40 percent. The expected level of EBIT for the firm over the coming year is $1.7 million with a standard deviation of $200,000. (Assume that EBIT is normally distributed.)
If the firm acquires the cars and finances them with debt as proposed, what is the increase in the probability of the company generating losses during the coming year?