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 $2.1 million dollars would be raised by selling 82,000 shares of common stock.

- Plan B would involve issuing $1.1 million in long-term bonds with an effective interest rate of 12.1 percent plus another $1.0 million would be raised by selling 41,000 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 a 34 percent 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

(a) Let Indifference level of EBIT = X

Now, EPS under Plan A = 0.66X/82000

EPS under plan B = (X-$1.1m*12.10%)(1-0.34)/41000

0.66X/82000 = (X-$1.1m*12.10%)(1-0.34)/41000

X = $266200

(b) Statement showing EPS under both the plans at EBIT of $549037.50

Particulars Plan-A Plan-B EBIT $266200 $266200 Less: Interest nil $133100 EBT $266200 $133100 Less:Tax@34% $90508 $45254 EAT $175692 $87846 No. of Equity shares 82000 41000 EPS 2.14 2.14

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