abe Forrester Abe Forrester and three of his friends from college have intereste

Question

abe Forrester

Abe Forrester and three of his friends from college have interested a group of venture capitalists in backing their business idea. The proposed outlets to distribute and service a full line of vacuum cleaners and accessories. These stores would be located in Dallas, Houston, and two plans have been proposed: Plan A is an all-common-equity structure in which $2.2 million dollars would be raised by selling 80,000 shares of common stock. Plan B would involve issuing $1.2 million in long-term bonds with an effective interest rate of 12.1 percent plus another $1.0 million would be raised by selling 40,000 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: Find the EBIT indifference level associated with the two financing plans. 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. The EBIT indifference level associated with the two financing plans is $ (Round to the nearest dollar.)

Explanation / Answer

Answer:

(a)

Let the indifference EBIT be x.

Then EPS under both option with x EBIT will be same.

Hence,

(Plan A) x - interest - tax / Equity shares = (Plan B) x - interest - tax / Equity shares

(x - 0 - .34x)/80,000 = x - 1,200,000 *12.1% - .34*(x - 1,200,000 *12.1%) / 40,000

.66x *40,000 = (.66x - 95,832) * 80,000

x = $290,400

Indifference EBIT is $290,400.

(b)

Plan A (In $) Plan B (In $) EBIT                 290,400          290,400 Less: Interest (1,200,000 *12.1%)                             -            145,200 EBT ( EBIT - Interest)                 290,400          145,200 Less: Tax @34%                    98,736            49,368 EAT (EBT - Tax)                 191,664            95,832 Equity Shares                    80,000            40,000 EPS = EAT/Number of equity shares                        2.40                 2.40

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