Three recent graduates of the computer science program at th

Three recent graduates of the computer science program at the University of Tennessee are forming a company that will write and distribute new application software for the iPhone. Initially, the corporation will operate in the southern region of Tennessee, Georgia, North Carolina, and South Carolina. A small group of private investors in the Atlanta, Georgia area is interested in financing the startup company and two financing plans have been put forth for consideration: The first (Plan A) is an all-common-equity capital structure. $2.0 million dollars would be raised by selling common stock at $20 per common share Plan B would involve the use of financial leverage. $1.0 million dollars would be raised by selling bonds with an effective interest rate of 11.0 percent (per annum), and the remaining $1.0 million would be raised by selling common stock at the $20 price per share. The use of financial leverage is considered to be a permanent part of the firm\'s capitalization, so no fixed maturity date is needed for the analysis. A 30 percent tax rate is deemed appropriate for the analysis. a. Find the EBIT indifference level associated with the two financing plans. b. A detailed financial analysis of the firm\'s prospects suggests that the long-term EBIT will be above $300,000 annually. Taking this into consideration, which plan will generate the higher EPS? a. The EBIT indifference level associated with the two financing plans is 220.000 (Round to the nearest dollar.)

Solution

a. EBIT indifference level is that level at which EPS is the same.

Plan A: Capital raised = $2 million. No. of equity shares issues = $2 million/$20

= 100,000 shares. In this option interest expense = 0.

Thus EPS = [EBIT*(1-tax rate)]/100,000 shares

= [EBIT*(1-0.3)]/100,000

= 0.7*EBIT/100,000

Plan B: No of shares = $1 million/$20 = 50,000 shares. Interest = 11% of $1 million = $110,000

Thus EPS = [(EBIT-110,000)*(1-0.3)]/50,000

At indifference point, 0.7*EBIT/100,000 = [(EBIT-110,000)*(1-0.3)]/50,000

Or , EBIT indifference level = 220,000

b. Plan A:

Plan B:

Thus EPS = 2.66 (2 decimal places) or 2.7 (1 decimal place) for plan B when EBIT is $300,000

EBIT	300,000.00
less: interest expense	0.00
Profits befor tax (PBT)	300,000.00
Less: tax @30%	-90,000.00
Net income	210,000.00
No. of shares	100,000.00
EPS	2.10