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 financial breakeven point for each plan

Explanation / Answer

Answer:

Plan A.

Issue of 14% Bonds for $4.5 Million :

We assume Financial Break even when PBT =0

Or EBIT – Interest =0

Here interest components are :

12% on $20,000,000 = $2,400,000

14% on $4,500,000= $630,000

Total interest = $3,030,000

Therefore the financial breakeven point for plan A will be EBIT of $3,030,000 when PBT will be nil and there will be no profit no loss.

Plan B.

Securing $4.5 million by sale of 100,000 shares;

Here the Interest component will be 12% on $ 20,000,000>

Therefore , the financial break even point will be EBIT of $ 2,400,000 as the PBT will be 0 and there will be no profit no loss.

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