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 $2.4 million dollars would be raised be selling 84,000 shares of common stock. • Plan B would involve issuing $1.3 million dollars in long-term bonds with an effective interest rate of 11.7% plus $1.1 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 a 40% 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.

Explanation / Answer

A./

INDIFFRENCE EBIT

[(X - I1) (1 - T)] / S1 = [(X - I2) (1 - T)] / S2

X = EBIT INDIFFERENCE LEVEL

I1 = FIXED INTEREST COSTS UNDER ALTERNATIVE 1.

I2 = FIXED INTEREST COSTS UNDER ALTERNATIVE 2.

T = TAX RATE

S1 = NUMBER OF EQUITY SHARES OUTSTANDING UNDER ALTERNATIVE 1.

S2 = NUMBER OF EQUITY SHARES OUTSTANDING UNDER ALTERNATIVE 2.

PLAN A

INTEREST = $0

NUMBER OF COMMON SHARE = 84000

PLAN B

INTEREST ($1300000 * 11.7%) = $152100

NUMBER OF EQUITY SHARE = 42000

[(X - 0) (1 - 0.40)] / 84000 = [(X - $152100) (1 - 0.40)] / 42000

0.6X / 84000 = (0.6X - $91260) / 42000

25200X = 50400X - $7665840000

25200X = $7665840000

X = $304200

B./

PLAN A PLAN B EBIT $304200 $304200 LESS INTEREST ($0) ($152100) PROFIT BEFORE TAX $304200 $152100 LESS TAX $121680 $60840 PROFIT AFTER TAX $182520 $91260 NUMBER OF COMMON STOCK 84000 42000 EPS $2.17 $2.17

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