Break point question...plz help!!!

CFA Level I
#1

The omni corp has a target capital structure of 60% equity and 40 % debt. The schedule of financing costs for the Omni corp is shown below… Amt of new debt after tax cost of debt amt of new equity cost of equity 0-99 4.2 0-199 6.5 100-199 4.6 200-399 8.0 200-299 5.0 400-599 9.5 calculate the break points ??? now do we have 4 break points or 6 break points??? plz help Thanks

#2

The break point is where the rate changes. The first time there is a break point is when debt hits 100 - then when debt reaches 200 - then when equity hits 200 and then when equity reaches 400. Remember before debt is 100 and before equity is 200 there is no change in rate. There is therefore 4 break points.

#3

You’ll have a break point each time a component cost of capital changes: BP 1 debt is $100. Total financing = 100/.4 = 250. BP 2 equity is $200. Total financing = 200/.6 = 333.34 BP 3 debt is $200. Total financing = 200/.4 = 500. BP 4 equity is $400. Total financing = 400/.6 = 666.67 BP 5 debt is $300. Total financing = 300/.4 = 750. BP 6 equity is $600. Total financing = 600/.6 = 1000

#4

BP 5 debt is $300. Total financing = 300/.4 = 750, but you don’t have an interest rate for more than 300 debt, so at this break point no debt can be raised BP 6 equity is $600. Total financing = 600/.6 = 1000, but this is not possible because there is neither a rate for equity, nor one for debt at 400 so at this break point neither debt not equity can be raised You’ll have 4 BP

#5

thanks …concept is all clear now…

#6

At B5 you would still be able to raise capital, through equity, but you would affect the structure of the capital (you would have more than 60% equity).

#7

You know, I’ve been studying for 4 months and this discussion doesn’t even look remotely familiar to me…darn. I assume this is somewhere in FSA?

#8

Nope, this is in corporate finance, in volume 4

#9

Thanks map1