Amarillo Parts is considering purchasing a small firm in the same line of busine

Question

Amarillo Parts is considering purchasing a small firm in the same line of business. The purchase would be financed by either the sale of common stock or by a bond issue. The financial manager wants to evaluate how the two alternative financing plans will affect the earnings potential of the firm. Total financing required is $4.5 million. The firm currently has $20,000,000 of 12 percent bonds and 600,000 common shares outstanding. The firm can arrange financing of the $4.5 million through a 14 percent bond issue or the sale of 100,000 shares of common stock. The firm has a 40 percent tax rate.

(a) What is the degree of financial leverage for each plan at $7,000,000 of EBIT?

(b) What is the financial breakeven point for each plan?

Explanation / Answer

If financing is done completely with issue of bonds

EBIT 7000000

Less : Interest paid ( 20000000*12%+4500000*14%) 3030000

EBT 3970000

Less : Tax ( 3970000*40%) 1588000

Earning available for equity shareholders 2382000

Number of shares outstanding 600000

EPS 3.97

Degree of financial leverage = EBIT/EBT

= 7000000/3970000 i.e 1.763

If financing is done completely by issue of shares

EBIT = 7000000

Less : Interest ( 20000000*12%) = 2400000

EBT = 4600000

Less : Tax @ 40% (4600000*40%) = 1840000

Earning avialable for equity shareholders = 2760000

Number of shares outstanding = 700000

EPS = 3.94

Degree of financial leverage = EBIT / EBT

= 7000000/4600000 i.e 1.522

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