No further information is given Question 1 Chapter 12/Course Learning Objective

Question

No further information is given Question 1 Chapter 12/Course Learning Objective 3 7.5 Marks Jamil Hussein and Omar Asat are two entrepreneurs from the United Arab Emirates who have established a number of different successful joint businesses across the United Arab Emirates They are thinking of launching a new venture. The proposed plan involves the establishment of a series of international retail outlets to distribute and service a full line of indoor and outdoor furniture. The stores would be located in major high-traffic cities in the United Arab Emirates including Dubai, Abu Dhabi, and Sharjah. The entrepreneurs need to raise $8 million to launch the new business venture. They have developed two financing plans detailed as follows as alternative to finance the new venture Plan A is an all common equity structure, where $8 million would be raised by selling 500,000 shares of common stock Plan B would involve the use of long-term debt financing, where $6 million would be raised by issuing bonds with a 12% interest rate, and the remainder would come from selling 375,000 shares of common stock The applicable corporate tax rate is 30%. Required: Mr. Hussein and Mr. Asat have hired you on a consulting basis to do the following a. Find the EBIT indifference level associated with the two financing proposals. Show all teps, intermediary calculations and the final answer. (4 Marks) Prepare income statements for the two plans that prove EPS will be the same regardless of the plan chosen at the EBIT level found in Part (a). b. (3.5 Marks)

Explanation / Answer

CALCULATION OF EBIT INDIFFERENCE LEVEL Assume EBIT indifference level=X PLAN A: EBIT= $X Interest cost $0 Earning after interest before tax $X Tax rate=30% 0.3 Tax expense 0.3X Net Income=X-0.3X 0.7X Return on Equity=0.7X/8000000 PLAN B: EBIT= $X Interest cost $720,000 (6000000*0.12) Earning after interest before tax X-720000 Tax rate=30% 0.3 Tax expense 0.3(X-720000) Net Income=0.7*(X-720000) Return on Equity=(0.7*(X-720000))/2000000 Inorder tobe indifferent: 0.7X/8000000=(0.7*(X-720000))/2000000 X/8=(X-720000)/2 X=4X-2880000 3X=2880000 X=2880000/3= $960,000 EBIT indifference Level $960,000 b INCOME STATEMENT PLAN A: A EBIT $960,000 B Interest Expense $0 C=A-B Earning after tax and before interest $960,000 D=C*0.3 Tax expense $288,000 (0.3*960000) E=C-D Net Income $672,000 F Equity $8,000,000 G=E/F Return on Equity 8.40% PLAN B: A EBIT $960,000 B Interest Expense $720,000 (6000000*0.12) C=A-B Earning after tax and before interest $240,000 D=C*0.3 Tax expense $72,000 E=C-D Net Income $168,000 F Equity $2,000,000 G=E/F Return on Equity 8.40%

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