Question

?(EBIT-EPS analysis)?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 ?$2.5 million dollars would be raised by selling 88,000 shares of common stock.

Plan B would involve issuing ?$1.1 million in? long-term bonds with an effective interest rate of 12.1 percent plus another $ 1.4 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 35 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.

Answer 1

(a) Calculation of Indifference level of EBIT

[EBIT(1- tax rate)]/N₁ = [( EBIT - Interest ) ( 1 - Tax rate )]/N₂

where,

N₁ = Number of shares of common stock in Plan A

N2 = Number of shares of common stock in Plan B

EBIT( 1 - 0.35 )/88,000 = [(EBIT - 133,100) ( 1 - 0.35 )]/ 44,000

EBIT/88,000 = (EBIT - 133,100)/44,000

EBIT = 2(EBIT - 133,100)

EBIT = $266,200

Hence, indifference level of EBIT = $266,200

(b) Income statement

	Plan A	Plan B
EBIT	266,200	266,200
Less: Interest	0	- 133,100
EBT	266,200	133,100
Less: tax @35%	- 93,170	- 46,585
Net income	173,030	86,515
Number of shares of common stock	88,000	44,000
EPS = Net income/No. of shares of common stock	$1.966	$1.966

Hence, whether plan A is chosen or plan B is chosen, EPS will be same.