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 $2.2 million dollars would be raised by selling 88,000 shares of common stock.

Plan B Would involve issuing $1.4 million in long term bonds with an effective interest rate of 12.2 percent plus another $0.8 million would be raised by selling 44,000 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 permanant part of the firms capital structure.

Abe and his partners plan to use a 35 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

Solution A

At Indifference level EBIT, EPS under both financial plan is the same.

EPS = (EBIT – Interest) x(1- Tax rate )/ no. of shares

Plan A

EPS = (EBIT – 0) x (1-0.35)/ 88000

        = EBIT x 0.35 / 88000

Plan B

EPS = (EBIT – 1,400,000 x 0.122) x(1-0.35) / 44,000

EPS = (EBIT – 170,800) x0.65 / 44,000

Equating both EPS, we get:

EBIT x 0.65 / 88000 = (EBIT – 170,800) x0.65 / 44,000

EBIT = 2x EBIT - 341,600

EBIT = 341,600

So indifference level of EBIT would be 341,600.

Solution B

Proforma Income Statement

Plan A

Plan B

EBIT

341600

341600

(-) Interest

0

-170800

EBT

341600

170800

(-) Tax 35%

-119560

-59780

Net Income

222040

111020

EPS Plan A = 222040/88000 = 2.52

EPS Plan B = 111020/ 44000 =2.52

Plan A

Plan B

EBIT

341600

341600

(-) Interest

0

-170800

EBT

341600

170800

(-) Tax 35%

-119560

-59780

Net Income

222040

111020

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