. (EBIT-EPS analysis) Abe Forrester and three of his friends from college have i
ID: 2698513 • Letter: #
Question
. (EBIT-EPS analysis) Abe Forrester and three of his friends from college have interested a group of venture capitalists in backing their business idea. The proposed operation would consist of a series of retail outlets to distribute and service a full line of vacuum cleaners and accessories. These stores would be located in Dallas, Houston, and San Antonio. To finance the new venture two plans have been proprosed:
Plan A is all common-equity- structure in which 2.3 million dollars would be raised by selling 84,000 shares of common stock.
Plan B would involve issuing $1.1 million dollars in long term bonds with an effective interest rate of 11.6% plus $1.2 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 firm’s capital structure.
Abe and his partners plan to use 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.
a. Find the EBIT indifference level associated with the two financing plans.
The EBIT indifference level associated with the two financial plans is $__?
(Round to the nearest dollar)
Complete the segment of income statement
Explanation / Answer
Calculate the annual interest payments for a debt financing option. If you are borrowing $1,000 and the interest rate is 5 percent, then the annual interest payments are $50.2Calculate the annual dividend payments for each of the stock financing options. Assume that in this case you are offering a 6 percent annual interest rate--$60. Note that common stock options do not come with mandatory dividends.Subtract the interest or dividends from your projected annual earnings. Assume your projected annual earnings are $500. Both options leave you with $450 and $440, respectively. Common stock leaves you with $500, as there is no dividend.4Set a number of shares. Common stock will need to have more shares, as it needs to compensate for the lack of dividends. Assume you are selling 10 shares of debt, 10 shares of preferred stock and 20 shares of common stock.5Divide the number of shares by the earnings available. The equations for debt, preferred stock and common stock are 450/10, 440/10 and 500/20, or $45, $44 and $25. These are the values each share will sell for.6Repeat this process for different projected earnings levels.7Graph your results with EPS on the x axis and EBIT on the y axis and find where they intersect. The two points where the common stock intersect with the other two lines are your indifference points--the sales levels where it is irrelevant whether you use common stock or not.This is your answer
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