Ellington's Cabaret is planning a major expansion that will require $95 million of new financing. Ellington's currently has a capital structure consisting of $400 million of common equity (with a cost of 14 percent and 4 million shares outstanding), $50 million of preferred stock ($50 par, $5 dividend), and $200 million of long-term debt (with a coupon interest rate of 9 percent). The marginal tax rate is 40 per- cent, and the average tax rate is 30 percent.
To finance the expansion, Ellington is considering two sources of funding: (1) the sale of new shares of stock at a net price of $95 per share or (2) the sale of deben- tures at a coupon rate of 10 percent.
a. What is the level of EBIT at the indifference point between these two alternatives? What are the earnings per share at this level?
b. If the expected level of EBIT is $100 million with a standard deviation of $20 million, what is the probability of having unfavorable financial leverage if the debt financing alternative is chosen? (Assume that EBIT is normally distributed.)