Three recent graduates of the computer science program at the Univ of Tennessee

Question

Three recent graduates of the computer science program at the Univ of Tennessee are forming a company that will write and distribute new application software for the iPhone. Initially, the corporation will operate in the southern region of Tennessee, Georgia, North Carolina, and South Carolina. A small group of private investors in the Atlanta, Georgia area is interested in financing the group company and two financing plans have been put forth for consideration:

The first (Plan A) is an all common equity structure. $2.5 million dollars would be raised by selling common stock at $20 per common share.
Plan B would involve the use of financial leverage. $1.3 million dollars would be raised by selling bonds with effective interest rate of 10.7% (per annum), and the remaining $1.2 million would be raised by selling common stock at the $20 price per share. The use of financial leverage is considered to be a permanent part of the firm's capitalization, so no fixed maturity date is needed for the analysis. A 35% tax rate is deemed appropriate for the analysis.

a. Find the EBIT indifference level associated with the two financing plans.
The EBIT indifference level associated with the 2 financing plans is $ (round to nearest dollar)

b. A detailed financial analysis of the firm’s prospects suggests that the long-term EBIT will be above $340,000 annually. Taking this into consideration, which plan will generate the higher EPS?

EBIT $____________________

Less: Interest Expense ____________________

Earnings Before Taxes $ Less: Before Taxes Net Income $______________________

Number of Common Shares EPS $ ____________________

Explanation / Answer

a. Plan A : All Equity. SO Interest Outgo.EBIT & EBT will be same.

PLan B: Debt = $1.3M @10.7%. So Int = 10.7%*1.3M = 139100

So Tax Shield will be 139100*35% =48685

SO EBIT Indiff will be Tax Shield+Int = 139100-48685=90415

b. PLan A:

EBIT $340000

Less: Int Exp $0

EBT $340,000

Less:Taxes 35%*340000 =$119,000

Net Inc $221000

Number of Common Shares =$2.5m/$20 = 125000

So EPS = Net Inc/No of shares =$221000/125000 = $1.77

Plan B:

EBIT $340000

Less: Int Exp 10.7%*1.3M= $139100

EBT $200,900

Less:Taxes 35%*200900 =$70315

Net Inc $130585

Number of Common Shares =$1.2m/$20 = 60000

So EPS = Net Inc/No of shares =$130585/60000 =$2.18

So Plan B will generate higher EPS

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