AQ&Q has EBIT of $2 million, total assets of $10 million, stockholders' equity of $4 million, and pretax interest expense of 10 percent.
A. What is AQ&Q's indifference level of EBIT?
B. Given its current situation, might it benefit from increasing or decreasing its use of debt? Explain.
C. Suppose we are told AQ&Q's average tax rate is 40 percent. How does this affect your answers to (a) and (b)?
A. To determine AQ&Q's indifference level of EBIT, we need to calculate the EBIT at which the company would be indifferent between two financing options: all equity financing (no debt) and a combination of debt and equity financing.
The formula to calculate the indifference level of EBIT is:
Indifference Level of EBIT = (Interest Expense / (1 - Tax Rate))
Given that AQ&Q has a pretax interest expense of 10 percent and an average tax rate of 40 percent, we can substitute these values into the formula:
Indifference Level of EBIT = (0.10 / (1 - 0.40))
B. To determine whether AQ&Q might benefit from increasing or decreasing its use of debt, we need to analyze the relationship between the cost of debt (interest expense) and the return on equity.
If the return on equity (ROE) is higher than the cost of debt (interest expense), then increasing the use of debt might be beneficial as it can amplify the return to shareholders. However, if the cost of debt is higher than the ROE, increasing the use of debt can lead to financial distress and reduced profitability.
We can calculate the ROE using the formula:
ROE = Net Income / Stockholders' Equity
C. Suppose we are told AQ&Q's average tax rate is 40 percent. Let's consider how this affects the answers to parts (a) and (b):
(a) The indifference level of EBIT calculation in (a) would remain the same since the average tax rate does not impact the calculation.
(b) The average tax rate affects the cost of debt since interest expense is tax-deductible. With a higher tax rate, the tax shield provided by the interest expense would be larger, reducing the after-tax cost of debt. Therefore, increasing the use of debt might be more beneficial, as the tax advantage outweighs the cost of debt.
It's important to note that these answers are based on the given information and assumptions, and further analysis can provide more accurate insights.