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 ​$2.5 million dollars would be raised by selling 84,000 shares of common stock.

Plan B would involve issuing ​$1.2 million in​ long-term bonds with an effective interest rate of 11.5 percent plus another $1.3 million would be raised by selling 42,000 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 34 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

EBIT indifference point would be that level of EBIT at which EPS under both the plans is equal

Let it be x

X(1-34%)/84,000 = (X-138,000)(1-34%)/42,000

0.66x*42,000 = (0.66x – 91,080)*84,000

27,720x = 55,440x – 7,650,720,000

X = $276,000

Hence, EBIT indifference level = $276,000

b.

	Plan A	Plan B
EBIT	276,000	276,000
Less: Interest	0	138,000
EBT	276,000	138,000
Less: Tax-34%	93,840	46,920
Earnings after tax	182,160	91,080
Number of shares	84,000	42,000
EPS	2.169	2.169