Question

5. Hi-Grade Regulator Company currently has 100,000 shares of common stock outstanding with a market price of $60 per share. It also has $2 million in 6 percent bonds. The com- pany is considering a $3 million expansion program that it can finance with all common stock at $60 a share (option 1), straight bonds at 8 percent interest (option 2), preferred stock at 7 percent (option 3), and half common stock at $60 per share and half 8 percent bonds (option 4).

a. For an expected EBIT level of $1 million after the expansion program, calculate the earnings per share for each of the alternative methods of financing. Assume a tax rate of 50 percent.

b. Construct an EBIT-EPS chart. Calculate the indifference points between alternatives. What is your interpretation of them?

Answer 1

a)

	Instruments	Option 1	Option 2	Option 3	Option 4
EBIT (in m)		1	1	1	1
op Bonds	2m@6%	-0.12	-0.12	-0.12	-0.12
opt2-Bonds	3m@8%		-0.24
opt4-Bonds	1.5m@8%				-0.12
NOI		0.88	0.64	0.88	0.76
less tax		0.44	0.32	0.44	0.38
NI		0.44	0.32	0.44	0.38
Less:opt3-PS	3m@7%			-0.21
NI to CS		0.44	0.32	0.65	0.38
op CS		100000	100000	100000	100000
opt1-CS		50000
opt4-CS					25000
Total CS		150000	100000	100000	125000
EPS (in $)		2.93	3.2	6.5	3.04
b)
Indifference EBIT-EPS			$3.20		$3.40

EBIT-EPS chart attachment is not possible.