AQ&Q has EBIT of $2 million, total assets of $10 million, stock holder’s 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 to AQ&Q’s average tax rate is 40 percent. How does this affect your answers to (A) and (B)?
AQ&Q has EBIT of $2 million, total assets of $10 million, stock holder’s 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 to AQ&Q’s average tax rate is 40 percent. How does this affect your answers to (A) and (B)?
To find the answers, we need to understand the concept of indifference level of EBIT and analyze the balance sheet of AQ&Q, along with its tax rate. Let's go step by step:
a) Indifference level of EBIT is the level of earnings before interest and taxes (EBIT) at which a firm's earnings per share (EPS) will be the same, regardless of the financing method (debt or equity) used. To calculate the indifference level of EBIT, we can use the formula:
Indifference Level of EBIT = (Interest Expense / (1 - Tax Rate))
Given that the pretax interest expense is 10 percent, and the tax rate is not provided, we will assume a tax rate of 40 percent based on the information provided in question (c). Thus, the indifference level of EBIT can be calculated as follows:
Indifference Level of EBIT = (0.10 / (1 - 0.40))
Indifference Level of EBIT = 0.10 / 0.60
Indifference Level of EBIT = 0.1667
Therefore, AQ&Q's indifference level of EBIT is 0.1667 or 16.67%.
b) To determine whether AQ&Q would benefit from increasing or decreasing its use of debt, we need to consider the stockholder's equity and total assets. When debt increases, it generally increases financial leverage, which can amplify both returns and risks. In this case, AQ&Q's stockholder's equity is $4 million, and its total assets are $10 million.
If AQ&Q were to increase its use of debt, it would lead to a higher proportion of debt in the overall capital structure. This might increase the financial risk, especially if the firm's profitability is low or uncertain. On the other hand, increasing debt can also provide tax advantages due to the tax-deductibility of interest expense.
Without additional information about AQ&Q's profitability, growth prospects, and the cost of debt, it is difficult to determine if increasing or decreasing the use of debt would be beneficial. However, if the firm has consistent high profitability and low financial risk, it might benefit from increasing its use of debt to take advantage of the tax benefits associated with interest expense.
c) If we consider AQ&Q's average tax rate of 40 percent, it affects the formula used to calculate the indifference level of EBIT. The new formula considering the tax rate becomes:
Indifference Level of EBIT = (Interest Expense / (1 - Tax Rate))
Given that the pretax interest expense is 10 percent and a tax rate of 40 percent, we can calculate the new indifference level of EBIT as follows:
Indifference Level of EBIT = (0.10 / (1 - 0.40))
Indifference Level of EBIT = 0.10 / 0.60
Indifference Level of EBIT = 0.1667
So, the average tax rate of 40 percent does not affect the calculation of AQ&Q's indifference level of EBIT. However, it is essential to consider this tax rate when evaluating the impact of debt on the firm's overall financial position and profitability.