(EBIT-EPS analysis) Abe Forrester and three of his friends from college have int

Question

(EBIT-EPS analysis) 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 proprosed:
Plan A is all common-equity- structure in which 2.3 million dollars would be raised by selling 84,000 shares of common stock.
Plan B would involve issuing $1.1 million dollars in long term bonds with an effective interest rate of 11.6% plus $1.2 million would be raised by selling 42,000 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 firm’s capital structure.
Abe and his partners plan to use 34% 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.

a. Find the EBIT indifference level associated with the two financing plans.

The EBIT indifference level associated with the two financial plans is $__?
(Round to the nearest dollar)

Complete the segment of income statement

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

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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