Question

Management of Total S.E.A. Inc. is considering two alternative financing plans. The detailed information is given in the table below.

The par value of common stock is $10, preferred stock has $100 par value and pays 15% dividend, and long-term debt is presented by 10-year bonds of $1,000 par value and a fixed annual coupon rate of 8%. The corporate income tax rate is 30%.

What is the breakeven EBIT? Which option is better if the forecasted EBIT is $2,200,000?

Guide to answer Illustration 2:

The first step of EBIT-EPS analysis is to find the indifference point. Thus, we have to calculate interest expense and preferred dividends for each financing plan.
Plan A: Cost and number of common stocks issued

IA = $5,000,000 × 8% = $400,000 PDA = $3,000,000 × 15% = $450,000 SA = $15,000,000 ÷ 10 = 1,500,000

Plan B: Cost and number of common stocks issued IB = $13,000,000 × 8% = 1,040,000
PDB = $2,000,000 × 15% = $300,000
SB = $8,000,000 ÷ 10 = 800,000

Answer 1

Break even point calculation formula =

Point of EBIT at which Plan A Eps = Plan B Eps

((EBIT - interest)*(1-tax rate))- Preference dividend/ No. Of shares = ((EBIT - Interest)*(1-tax rate)) - Preference dividend / No. Of shares

((EBIT -400000)*(1-0.30)-450000)/1500000. = ((EBIT - 1040000)*(1-0.30))-300000)/800000

(0.70EBIT - 280000)-450000)/1500000 = ( (0.70 EBIT - 728000)-300000)/800000

Divide both sides by 100000 and solve the equation

(0.70 EBIT - 730000) / 15. = ( 0.70 EBIT - 1028000)/8

5.6 EBIT - 5840000 = 10.5 EBIT - 15420000

9580000 = 4.9 EBIT

EBIT = 1955102

So, EBIT indifference point is $1,955,102.

If forecasted EBIT is more than break even then plan for More debt is to be used. So plan B is better.