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 $2.2 million dollars would be raised by selling 88,000 shares of common stock. Plan B would involve issuing $1.4 million dollars in long-term bonds with an effective interest rate of 12.1% plus $.8 million would be raised by selling 44,000 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% 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 financing plans is $? Round to the nearest dollar.

Explanation / Answer

= EBIT indifference level

I1 = Fixed interest costs under Plan A

I2 = Fixed interest costs under Plan B

T = Tax rate

S1 = Number of equity shares outstanding under Plan A

S2 = Number of equity shares outstanding under Plan B

{(X-0)(1-.38)}/80000= {(X-169400)(1-.38)}/44000

X = $ 378,536

Plan A Issuing 80000 common equity shares at $ 27.50 (=2.2*1000000/80000) Interest cost = Nil Plan B Debt = $ 1.4 million Interest = $ 169,400 no of quity shares =44000 he point of indifference can be calculated using the following formula: {(X-I1)(1-t)}/S1 =(X-I2)(1-t)/S2 Where

= EBIT indifference level

I1 = Fixed interest costs under Plan A

I2 = Fixed interest costs under Plan B

T = Tax rate

S1 = Number of equity shares outstanding under Plan A

S2 = Number of equity shares outstanding under Plan B

{(X-0)(1-.38)}/80000= {(X-169400)(1-.38)}/44000

X = $ 378,536

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