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 cleaners 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 $2.5 million dollars would be raised by selling 90,000 shares of common stock. Plan B would involve issuing $1.4 million in long-term bonds with an effective interest rate of 12.2 percent plus another $1.1 million would be raised by selling 45,000 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 a 38 percent tax rate in their analysis, and they have hired you on a consulting basis to do the following: Find the EBIT indifference level associated with the two financing plans. 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. The EBIT indifference level associated with the two financing plans is (Round to the nearest dollar.) Complete the segment of the income statement for Plan A below: (Round income statement amounts to the nearest dollar except the EPS to the nearest cent.) Complete the segment of the income statement for Plan B below: (Round income statement amounts to the nearest dollar except the EPS to the nearest cent.)

Explanation / Answer

Answer:

(a) Calculation of EBIT Indifference level

EBIT Indifference level is "the level of Earning (EBIT) at which Earnings Per Share (EPS) under different financial plan [two capital mix] are expected to remain same irrespective of Debt-Equity Mix.

i.e. EPS under Plan A = EPS under Plan B

Formula to calculate EBIT Indifference Point / Level is as follows:

(EBIT - Interest) (1 - tax) / No. of Equity SharesPlan A = (EBIT - Interest) (1-Tax) / No. of Equity SharesPlan B

Here EBIT is the Indifference level.

(EBIT - 0) (1-0.38) / 90,000 = [EBIT - ($1,400,000 x 12.20%)] (1-0.38) / 45,000

0.62 EBIT / 90,000 = [(EBIT - $170,800) x 0.62] / 45,000

0.62 EBIT = 2 x (0.62 EBIT - $105,896)

0.62 EBIT = 1.24 EBIT - $211,792

1.24 EBIT - 0.62 EBIT = $211,792

0.62 EBIT = $211,792

EBIT = $211,792 / 0.62 = $341,600

At $341,600 EBIT Indifference level, EPS under two financing plan (Plan A and Plan B) are expected to remain same irrespective of Debt-Equity Mix.

(b).

Income Statement of Plan A

Income Statement of Plan B

EPS under both Plan is $2.35 i.e. SAME.

Stock Plan A Amount EBIT $341,600 Less: Interest Expenses $0 Earnings before taxes $341,600 Less: Taxes @ 38% $129,808 Net Income $211,792 Number of Common Stock 90,000 EPS = Net Income / Common Stock $2.35

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