A company has an EBIT of $4 million, and its degree of total leverage is 2.4. The firm's debt consists of $20 million in bonds with a 10 percent yield to maturity.
The company is considering a new production process that will require an increase in fixed costs but a decrease in variable costs. If adopted, the new process will result in a degree of operating leverage of 1.4. The president wants to keep the degree of total leverage at 2.4. If EBIT remains at $4 million, what amount of bonds must be outstanding to accomplish this (assuming the yield to maturity remains at 10 percent)?
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A. B. C. D. E.A
First, find the new DFL:
DTL = (DOL)(DFL)
2.4 = (1.4)(DFL)
DFL = 1.7143.
Then, find the new interest payments in a year:
DFL = (EBIT)/(EBIT - I)
1.7143 = ($4,000,000)/($4,000,000 - I)
I = $1,666,686.11.
Finally, solve for the new debt level, knowing that the yield to maturity remains at 10%. Debt Value(YTM) = Interest Payment
Debt(0.10) = $1,666,686.11 -
Debt = $16,666,861.11 = $16.7 million.