University Technologies, Inc. (UTI) has a current capital structure consisting of 10 million shares of common stock, $200 million of first-mortgage bonds with a coupon interest rate of 13 percent, and $40 million of preferred stock paying a 5 percent dividend. In order to expand into Asia, UTI will have to undertake an aggressive capital outlay campaign, expected to cost $200 million. This expansion can be financed either by selling 4 million new shares of common stock at a price of $50 per share or by the sale of $200 million of subordinated debentures at a pretax interest rate of 15 percent.
The company’s tax rate is 40 percent.
a. Compute the EBIT-EPS indifference point between the equity and debt financing alternatives.
b. If UTI expects next year’s EBIT to be $150 million with a standard deviation of $20 million, what is the probability that the equity financing option will produce higher earnings per share than the debt financing option? (Assume that EBIT is normally distributed).