B15-13 (book/static) Question Help (EBIT-EPS analysis) Threeecent graduates of t
ID: 2658379 • Letter: B
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B15-13 (book/static) Question Help (EBIT-EPS analysis) Threeecent 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 southem regin of Tennessee, Georgia, North Carolina, and South Carolina. A small group of private investors in the Allanta, Georgia area is interested in financinetatup company and two finaning plans have been put forth for consideration: The first (Plan A) is an all-common-equity capital structure. $2.0 million dolars would be raised by selling common stock at $20 per common share *Plan B would involve the use of financial leverage. $1.0 million dollars would be raised by selling bonds with an effective interest rate of 11.0 percent (per annum), and the remaining $1.0 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 fim's capitalization, so no fixed maturity date is needed for the analysis. A 30 percent tax rate is deemed appropriate for the analysis. a. Find the EBIT indifference level associated with the two financing plans. b. A detailed financial analysis of the firm's prospects suggests that the long-term EBIT will be above $300,000 annually. Taking this into consideration, which plan will generate the higher EPS?Explanation / Answer
a) EBIT indifference level is that level of EBITat which both the financial plans will have equal EPS. EPS under Plan A = E*0.65/100000 EPS under Plan B = (E-1000000*11%)*0.65/50000 where E=the Indifference level EBIT Equating the EPS of the two plans at the indifference level and solving for E, we have: E*0.65/100000=(E-110000)*0.65/50000 E*0.65*1 = E*2*0.65-110000*2*0.65 0.65*E=110000*1.3 E = 110000*1.3/0.65 = $220,000 CHECK: PLAN A PLAN B INDIFFERENCE LEVEL EBIT $ 2,20,000 $ 2,20,000 Interest $ - $ 1,10,000 EBT $ 2,20,000 $ 1,10,000 Tax at 40% $ 88,000 $ 44,000 NI $ 1,32,000 $ 66,000 Number common shares outstanding $ 1,00,000 $ 50,000 EPS $ 1.32 $ 1.32 b) As the expected EBIT level is more than the Indifference level EBIT, the Plan B with debt will give more EPS, as the advantage of leverage takes effect. CHECK: PLAN A PLAN B $ 3,00,000 $ 3,00,000 $ - $ 1,10,000 $ 3,00,000 $ 1,90,000 $ 1,20,000 $ 76,000 $ 1,80,000 $ 1,14,000 $ 1,00,000 $ 50,000 $ 1.80 $ 2.28
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