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

Question

Abe Forrester and three of his friends from college have interested a croup fo 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 vaccum cleaners and accessories. These stores would be located in Dallas,Houston,and San Antonia. 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 $1.2 million dollars in long term bonds with an effective interest rate of 11.7% plus $1.3 million would be raised by selling 44,000 shares of common stock. The debt funds raised under Abe and his partners plan to use a 38% 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

EBIT indifference level associated with the two financing plans is $319,800. 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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