The GCI Corporation is planning a $4,000,000 expansion this year. The expansion

Question

The GCI Corporation is planning a $4,000,000 expansion this year. The expansion can be financed by issuing either common stock or bonds. The new common stock can be sold for $60 per share. The bonds can be issued with a 12 percent coupon rate. The firm's existing shares of preferred stock pay dividends of $2.00 per share. The company's corporate income tax rate is 46 percent. The company's balance sheet prior to expansion is as follows: GCI Corporation Current Assets $2,000,000 Fixed Assets 8,000,000 Total Assets $10,000,000 Current Liabilities $1,500,000 Bonds: (8%, $1,000 par value) 1,000,000 (10%, $1,000 par value) 4,000,000 Preferred Stock: ($100 par value) $500,000 Common Stock: ($2 par value) 700,000 Retained Earnings 2,300,000 Total Liabilities and Equity $10,000,000 a) Calculate the indifference level of EBIT between the two plans. b) If EBIT is expected to be $3 million, which plan will result in higher EPS?

Explanation / Answer

a) Indifference level is that level of EBIT for which EPS is the same: EPS for the plan with equity financing = [(E-1000000*8%-4000000*10%)*54%-5000*2]/(350000+4000000/60) EPS for the plan with debt financing = [(E-1000000*8%-4000000*10%-4000000*12%)*54%-5000*2]/(350000) Equating the two, and solving for E (EBIT) EPS for the plan with equity financing = [(E-1000000*8%-4000000*10%)*54%-5000*2]/(350000+4000000/60)= [(E-1000000*8%-4000000*10%-4000000*12%)*54%-5000*2]/(350000) [(E-480000)*0.54-10000)]/41.6667 = [(E-960000)*0.54-10000)]/35 [(35E-16800000)*0.54-350000 = [(41.67E-40003200)*0.54-416667 18.9E-9422000=22.50E-22018395 3.6E = 12596395 E = 3,498,999 (Answer: INDIFFERENCE LEVEL OF EBIT BETWEEM THE TWO PLANS) CHECK: EQUITY PLAN DEBT PLAN EBIT $        3,498,999 $        3,498,999 Less: Interest: 1000000*8% $              80,000 $              80,000 4000000*10% $            400,000 $            400,000 4000000*12% $                       -   $            480,000 EBT $        3,018,999 $        2,538,999 Tax at 46% $        1,388,740 $        1,167,940 NI $        1,630,259 $        1,371,059 Preferred stock dividend (5000*$2) $              10,000 $              10,000 NI available for distribution to common stock shareholders $        1,620,259 $        1,361,059 Number of shares: Existing (700000/2) $            350,000 $            350,000 New shares = 4000000/60 = $              66,667 $                        -   Total number of shares $            416,667 $            350,000 EPS $                   3.89 $                   3.89 b) If the expected level of EBIT is 3 million, the equity plan will result in higher EPS. For levels of EBIT less than the EBIT indifference level, the equity plan will have higher EPS and for levels of EBIT greater than the EBIT indifference level, the debt plan will have higher EPS.

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