A company currently sells 75,000 units annually. At this sales level, its EBIT is $4 million, and its degree of total leverage is 2.0. The firm's debt consists of $15 million in bonds with a 9.5 percent coupon. The company is considering a new production method which will entail an increase in fixed costs but adecrease in variable costs, and will result in a degree of operating leverage of 1.6. The president, who is concerned about the stand-alone risk of the firm, wants to keep the degree of total leverage at 2.0. If EBIT remains at $4 million, what amount of bonds must be retired to accomplish this?
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A. B. C. D. E.C
DTL = (DOL)(DFL)
2.0 = 1.6(DFL)
1.25 = DFL.
1.25 = $4,000,000/($4,000,000-I)
$5,000,000 - 1.25(I) = $4,000,000
I = $800,000.
Debt = $800,000/.095 = $8,421,053.
Must retire = $15,000,000 - $8,421,053 = $6.58 million of debt.