Abe Forrester and three of his friends from college have interested a group of v

Question

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 90,000 shares of common stock. *Plan B would involve issuing $1.2 million dollars in long-term bonds with an effective interest rate of 11.9% plus another $1.3 million would be raised by selling 45,000 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 firms capital structure. Abe and his partners plan to use a 40% 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 fprma income statement for the EBIT level solved in Part A. the shows that EPS will be the same regarless whether Plan A or Plan B is chosen.

Explanation / Answer

Stock Plan A

EBIT $319,800

Less: Interest Expense 0

Earnings Before Taxes $319,000

Less: Taxes at 40% (127,920)

Net Income $191,880

Number of Common Shares 84,000

EPS 2.28

Income Statement for Plan B

EBIT $319,800

Less: Interest Expense (159,900)

Earnings Before Taxes 159,900

Less: Taxes at 40% (63,960)

Net Income 95,940

Number of Common Shares 42,000

EPS 2.28

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