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 $2.3 million dollars would be raised by selling 90,000 shares of common stock. Plan B would involve issuing $1.3 million in long-term bonds with an effective interest rate of 11.8 percent plus another $1.0 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.)

Explanation / Answer

A)Under indifference point ,Earning per share under both alternative are equal.

Interest on debt under plan B= 1,300,000*.118 = 153400

EPS under Plan A = EPS under plan B

EBIT (1-Tax) /Number of shares =   (EBIT - I)(1-Tax) /Number of shares

    EBIT(1-.38) /90000 = (EBIT -153400) (1-.38) / 45000

    .62EBIT/ 90000 = .62(EBIT -153400)/45000

      .62*45000 EBIT /90000 = .62 (EBIT -153400)

         .31 EBIT = .62 (EBIT -153400)

          EBIT = .62/.31 (EBIT -153400)

            EBIT = 2 EBIT - 306800

           2EBIT -EBIT = 306800

             EBIT = 306800

2)

        

EBIT 306800 Less Interest 0 EBT 306800 Less:tax    [306800*.38] - 116584 EAT 190216 Number of shares 90000 EPS      [190216/90000] 2.1135

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