Question

Question:

Tea-Tree Bay Limited is considering two financing plans to raise $10 million. The company tax rate is 28%.

Plan A: This plan is an all-ordinary share plan, where the company sells 1,000,000 shares at $10 per share.

Plan B: This plan uses financial leverage. The company is considering a debt (Bonds) Issue with a 20-year maturity period. The bond issue will carry a coupon rate of 5.5% per annum, and the principal borrowed will amount to $5 million, and the remaining $ 5 million would be raised by selling ordinary shares at $10 per share. The financial leverage option is considered to be a permanent part of the company’s capitalisation, and hence no fixed maturity date is needed for the analysis.

Required:

Find the EBIT indifference level associated with the two financing plans.

(Note: All workings must be provided)

Answer 1

EBIT indifference level is that level if EBIT under which the EPS of the Both the paln will be same.

hence

= Interest under Plan A = $0

= Interest under Plan B= $5000000*5.5% = $275000

PD = Preference dividend = $0

= Number of Shares under Plan A = 1,000,000 shares

= Number of Shares under Plan B = $ 5 million / $10 Per share = 500000 shares

t= tax rate = 28% = 0.28

hence

=>EBIT = $550000

EBIT indifference level associated with the two financing plans = $550000