(Related to Checkpoint 15.2) (EBIT-EPS analysis) Abe Forrester and three of his

Question

(Related to Checkpoint 15.2) (EBIT-EPS analysis) Abe Forrester and three of his friends from college have interested a group of venture capitalists in backing their business idea. The proposed operation would consist of a series of retail outlets to distribute and service a full line of vacuum cleaners and accessories. These stores would be located in Dallas, Houston, and San Antonio. To finance the new venture two plans have been proposed: bullet

Plan A is an all-common-equity structure in which $2.2 million dollars would be raised by selling 82,000 shares of common stock. bullet

Plan B would involve issuing $1.2 million in long-term bonds with an effective interest rate of 11.7 percent plus another $ 1.0 million would be raised by selling 41000 shares of common stock. The debt funds raised under Plan B have no fixed maturity date, in that this amount of financial leverage is considered a permanent part of the firm's capital structure.

Abe and his partners plan to use a 35 percent tax rate in their analysis, and they have hired you on a consulting basis to do the following:

a. Find the EBIT indifference level associated with the two financing plans.

b. Prepare a pro forma income statement for the EBIT level solved for in part a that shows that EPS will be the same regardless whether Plan A or B is chosen.

Explanation / Answer

a). At indifference point the EPS of both options will be the same,

     EPS under Plan A:

     [EBIT * (1 – Tax Rate)]/number of shares

     Here,

    Number of Shares = 82,000

    Net Income under Plan B:

    [(EBIT – Interest)*(1 – Tax Rate)]/number of shares

    Here,

    Interest = $1,200,000 * 11.7% = $140,400

    Tax Rate = 35% = 0.35

    Number of shares = 41,000

    At indifference point:

    [EBIT(1-0.35)/82,000] = [(EBIT – 140,400)*(1-0.35)]/41,000

    EBIT*0.65/2 = EBIT*0.65 – 91,260

    91,260 = EBIT*0.65 – EBIT*0.325

    EBIT = 91,260/0.325

    EBIT = $280,800

At EBIT of $280,800 lies the indifference point between the two options.

b).

EBIT                                                                       280,800

Less: Interest Expense                                         nil           

EBT                                                                         280,800

Less: Taxes @ 35%                                           98,280

Net Income                                                       182,520

Number of common shares                        82,000

EPS (182,520/82,000)                                      $2.2259

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