Question

Lenow’s Drug Stores and Hall’s Pharmaceuticals are competitors in the discount drug chain store business. The separate capital structures for Lenow and Hall are presented here:

Lenow		Hall
Debt @ 10%	\(100,000	Debt @ 10%	\)200,000
Common stock, \(10 par	200,000	Common stock, \)10 par	100,000
Total	\(300,000	Total	\)300,000
Shares	20,000	Common shares	10,000

c. If the cost of debt went up to 12 percent and all other factors remained equal, what would be the break-even level for EBIT?

Short answer

The break-even level of EBIT is $36,000.

Step-by-step solution

Break-even EBIT of two competitor companies

The breakeven EBIT of two competitor company is the level at which earning of the company is equal to the fixed charges of the company.

Break-even level for EBIT

$\begin{array}{rcl}\frac{\left(\mathrm{EBIT}-\mathrm{Interest}\right)\left(1-\mathrm{Tax}\right)}{\mathrm{No}.\mathrm{of}\mathrm{shares}}& =& \frac{\left(\mathrm{EBIT}-\mathrm{Interest}\right)\left(1-\mathrm{Tax}\right)}{\mathrm{No}.\mathrm{of}\mathrm{shares}}\\ \frac{\left(\mathrm{EBIT}-\$12,000\right)\left(1-0.30\right)}{20,000}& =& \frac{\left(\mathrm{EBIT}-\$24,000\right)\left(1-0.30\right)}{10,000}\\ \frac{0.70\mathrm{EBIT}-\$8,400}{20,000}& =& \frac{0.70\mathrm{EBIT}-\$16,800}{10,000}\\ 0.70\mathrm{EBIT}-\$8,400& =& \frac{0.70\mathrm{EBIT}-\$16,800}{10,000}\times 20,000\\ \mathrm{EBIT}& =& 36,000\end{array}$