1. Abe Forrester and three of his friends from college have interested a group of venure capitalists in backing their business idea. The proposed operation would consist of a series of retail outlets to distribute and service a full line ot vacuum cleaners and accessories. These stores would be located in Dallas, Houston, and San Antonio. To finance the new venture two plans have been propsed:
-Plan A is an all-common-equity structure which $2.4million dollars would be raised by selling 84,000 shares of common stock.
-Plan B would involve issuing $1.5 million dollars in long-term bonds with effective interest rate of 11.6% plus 0.9 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 firms capital sturcture.
Abe and his partners plan to use a 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.
2. Three recent graduates of the computer science program at the university of Tennessee are forming a company that will write and distribute new application software for the iPhone. Initially the corporation will operate in the southern region of Tennessee, Georgia, North Carolina, and South Carolina. A small group of private investors in the Atlanta, Georgia area is interested in financing the startup company and two financing plans have been put forth for consideration:
The first plan (plan A) is an all-common-equity capital structure. 2.3 million dollars would be raised by selling common stock at $20 per common share
– Plan B would involve the use of financial leverage. 1.2 million dollars would be raised by selling bonds with an effective interest rate of 10.8% (per annum) and the remaining 1.1 million would be raised by selling common stock at the $20 price per share. The use of financial leverage is considered to be a permanent part of the firms capitalization, so no fixed maturity date is needed for the analysis. A 30% tax rate is deemed appropriate for the analysis.
A. Find the EBIT indifference level associated with the two financial plans.
B. A detailed financial analysis of the firms prospects suggests that the long term EBIT will be above $329,000 annually. Taking this into consideration, which plan will generate the higher EPS?