3 Ahd little debt financing DIUVide them with free cash flow, their man- eit mig

Question

3 Ahd little debt financing DIUVide them with free cash flow, their man- eit might squander the firm's earnings o BIT-EPs analysis) Bill and Kate Theil are not only husband and wife but en- LC who have established three successful businesses. The proposed plan st effort involves a series of international retail outlets to distribute and fuull line of ingenious home garden tools. The stores would be located in y, Bogotá, São Paulo, and Bue- A is an all on stock. Plan B would involve the use of long-term debt financing. Three million dollars would be raised by marketing bonds with an effective interest for their latest high-traffic cities in Latin Americ nos Aires. The entrepreneurs have proposed two financing plans. Plan commo hares of common Pla a such as Panama Cit te of 14 percent. Under Plan B, another $2 million would be raised by selling 64,000 of common stock. With both plans, $5 million is needed to launch the new shares rm's operations. The debt funds raised under plan B are considered to have no fixed fi aturity date because this portion of financial leverage is thought to be a permanent part of the company's capital structure. The two promising entrepreneurs have de- cided to use a 35 percent marginal 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 proposals b. Prepare income statements for the two plans that prove EPS will be the same regardless of the plan chosen at the EBIT level found in part (a). 12-9, (EBIT-EPS aualusis) A groun of retired college professors has decided to form

Explanation / Answer

Solution to Part a Plan 1 EBIT - Interest(1-Tax Rate)/Outstanding Shares =EBIT - 0(1-35%)/160,000 =EBIT/160,000 --- Equation 1 Plan 2 EBIT - Interest(1-Tax Rate)/Outstanding Shares =EBIT - 3,000,000*14%*(1-35%)/64,000 =EBIT - 273,000/64,000 ---- Equation 2 Solving Equation 1 and 2 to find indiffernt EBIT level - EBIT/160,000 = EBIT-273000/64000 or, EBIT/160,000 - EBIT/64000 = -4.266 or, EBIT - 2.5EBIT = -4.266 * 160,000 or, -1.5 EBIT = -682,560 or, EBIT = 455,040 Solution to Part b EPS under Plan 1 = EBIT / Outstanding Shares = 455,040 / 160,000 =2.844 EPS under Plan 2 = EBIT - Interest*(1-Tax Rate) / Outstanding Shares = 455,040 - 420,000 * (1-35%) / 64,000 = 455,040 - 273,000 / 64,000 = 182,040/64000 = 2.844

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