Abe Forrester and three of his friends from college have interested a group of v

Question

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 cleaner and accessories. These stores would be located in Dallas, Houston, and San Antonio. To finance the new venture two plans have been proposed:

Plan A: is an all-common-equity structure in which 2.4million dollars would be raised by selling 84,000 shares of common stock

Plan B would involved issueing 1.4million in long term bonds with an effective interest rate of 11.6 percent plus another 1.0 million would be raised by selling 42,000 shares of common stock. The debt funds would be 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 structure.

Abe and his partners plan to use a 38% 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 financial plan.

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.

Explanation / Answer

Ans) A)324800

B)

EBIT EBIT(1-t)/N1=EBIT-Interest(1-t)/N2 Ebit(1-38/84000 = EBIT-162400(1-38%)/42000 Solving This we get EBIT 324800 Plan1 Plan2 EBIT 324800 324800 Less Interest 162400 EAT 324800 162400 Tax 38% 123424 61712 PAT 201376 100688 No of Share 84000 42000 EPS 2.40 2.40

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