Cybernauts, Ltd., is a new firm that wishes to determine an appropriate capital structure. It can issue 16 percent debt or 15 percent preferred stock. The total capitalization of the company will be $5 million, and common stock can be sold at $20 per share. The company is expected to have a 50 percent tax rate (federal plus state). Four possible capital structures being considered are as follows:
|
PLAN |
DEBT |
PREFERRED |
EQUITY |
|
1 |
0% |
0% |
100% |
|
2 |
30 |
0 |
70 |
|
3 |
50 |
0 |
50 |
|
4 |
50 |
20 |
30 |
a. Construct an EBIT EPS chart for the four plans. (EBIT is expected to be $1 million.) Be sure to identify the relevant indifference points and determine the horizontal axis intercepts.
b. Using Eq. (16.12), verify the indifference point on your graph between plans 1 and 3 and between plans 3 and 4.
c. Compute the degree of financial leverage (DFL) for each alternative at an expected EBIT level of $1 million.
d. Which plan is best? Why?
(16.12)