?(EBIT-EPS analysis)?Abe Forrester and three of his friends from college have in
ID: 2616200 • Letter: #
Question
?(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:
Plan A is an? all-common-equity structure in which ?$2.5 million dollars would be raised by selling 88,000 shares of common stock.
Plan B would involve issuing ?$1.1 million in? long-term bonds with an effective interest rate of 12.1 percent plus another $ 1.4 million would be raised by selling 44,000 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) Calculation of Indifference level of EBIT
[EBIT(1- tax rate)]/N1 = [( EBIT - Interest ) ( 1 - Tax rate )]/N2
where,
N1 = Number of shares of common stock in Plan A
N2 = Number of shares of common stock in Plan B
EBIT( 1 - 0.35 )/88,000 = [(EBIT - 133,100) ( 1 - 0.35 )]/ 44,000
EBIT/88,000 = (EBIT - 133,100)/44,000
EBIT = 2(EBIT - 133,100)
EBIT = $266,200
Hence, indifference level of EBIT = $266,200
(b) Income statement
Hence, whether plan A is chosen or plan B is chosen, EPS will be same.
Plan A Plan B EBIT 266,200 266,200 Less: Interest 0 - 133,100 EBT 266,200 133,100 Less: tax @35% - 93,170 - 46,585 Net income 173,030 86,515 Number of shares of common stock 88,000 44,000 EPS = Net income/No. of shares of common stock $1.966 $1.966Related Questions
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