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 by selling 80,000 shares of common stock. Plan B would involve issuing $1.2 million in long-term bonds with an effective interest rate of 11.8 percent plus another $1.2 million would be raised by selling 40,000 shares of common stock. The debt funds raised under Plan B have no fixed maturity date, in that this amount of financial leverage is considered a permanent part of the firm's capital structure. Abe and his partners plan to use a 40 percent tax rate in their analysis, and they have hired you on a consulting basis to do the following: a. Find the EBIT indifference level associated with the two financing plans. b. Prepare a pro forma income statement for the EBIT level solved for in part a that shows that EPS will be the same regardless whether Plan A or B is chosen. a. The EBIT indifference level associated with the two financing plans is$. (Round to the nearest dollar.) b. 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.) EBIT $ Less: Interest Expense $ Earnings Before Taxes $ Less: Taxes at 40% $ Net Income Number of Common Shares $ EPS $

Explanation / Answer

a. Computation of EBIT indifference level:

Let the EBIT indifference level be E.

E ( 1- T) / 80,000 = (E - 141,600) x ( 1-T) / 40,000 or

0.6 E x 40,000 = 80,000 ( 0.6 E - 84,960) or

E = $ 283,200

Therefore the EBIT Indifference level is $ 283,200 between the two plans.

b.

Stock Plan A B EBIT $ 283,200 $ 283,200 Less interest expense 0 141,600 Earnings before taxes $ 283,200 $ 141,600 Less Tax @ 40% $ 113,280 $ 56,640 Net income $ 169,920 $ 84,960 Number of common shares 80,000 40,000 EPS $ 2.124 $ 2.124

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