CFA Practice Question

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CFA Practice Question

A firm's cost of equity is 12%, which reflects a 4% premium over the cost of its long-term debt. The firm has an EBIT of $27,900 and $65,000 in debt. The firm is planning to increase its debt by $15,000, which will raise the cost of debt by 1% for the additional amount. What is the change in the company's pre-tax profit due to the additional debt?
A. -8.81%
B. -5.95%
C. -5.29%
Explanation: Cost of debt = Cost of equity - Risk premium = 12 - 4 = 8%
Current PBT = 27,900 - 0.08 x 65,000 = 27,900 - 5,200 = 22,700
Cost of additional 15,000 in debt is 9% (= 8 + 1).
New PBT = 27,900 - 0.08 x 65,000 - 0.09 x 15,000 = 27,900 - 6,550 = 21,350
Change in PBT = (21,350 - 22,700) / 22,700 = -0.0595, or -5.95%

User Contributed Comments 12

User Comment
iceluke first the profit before tax, then everything else should be clear
linr0002 additional amount is at 9% not full amt
Bibhu PBT - Profit before tax.
ksnider when calculating the new PBT dont you need to use the new debt level of 80,000 (65,000 + 15,000)?? if so you'd get -8.81% as the answer.
can someone explain why you wouldn't use 80K?
Boubena The new debt level is already used but at different rates: 8% for 65K and 9% for 15 K.
gill15 I would put this in the difficult section. Not crazy hard but I would not have got it without the solution.
SKIA Agree with Gill15
chris297 "1% for additional amount" has too many implications.
CJPerugini ^Agreed.
atlootah how did we get the 1% ??
atlootah nvm
Albireo Can someone please explain this in a simpler way? I don't understand it. What's throwing me off is how we calculate the new profit (and why we do it in such a way!).
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