Question

Your company is evaluating alternative plans to finance an expansion of its business as detailed below Your company is considering the best way to finance its new operating division which requires finance of $10m. Plan A involves all equity. Two million new shares will be issued at $5 each. Plan B involves the use of financial leverage. Five million dollars will be raised by selling bonds with a coupon interest rate of 10% p.a. Under this plan, the remaining $5m would be raised from issuing shares at $5 each. The use of financial leverage is considered to be a permanent part of the firm’s capitalisation so no maturity date is needed for the analysis. The company pays tax at the rate of 36% and currently has $1m debt on issue with a coupon interest rate of 10% p.a., and 2m shares. The current financial statements of the firm show earnings before interest and tax (EBIT) of $1,500,000 and earnings per share (EPS) of 41.6 cents. The new project is expected to add $1,200,000 to earnings before interest and tax.

a) Calculate the EBIT indifference point

b) For EBIT = $2,400,000 calculate the EPS for each plan and identify which plan the company should prefer.

Answer 1

Answer :-(PARTA: Previous EBIT (Earning Before Interest & Tones) = 1,500,000 Loh new phoyu евт преди - 1, уро, ооо - Total EBIT = 2,700,000 PLANA & Company finances through only equity then only prerious plenious a debt is taken: - EBIT = 2,700,000 Les Interest @10% = 600,000) Cloro million) 2,609000 Less: Tox Rate @ = (936,000) 361 Prestit ofte Tox = 1,664,000 EPS (Earning Per shave) - Netto come Dividends Weighted Average shares Where Net Income = Outstanding 1,664,000 Dividends = 0 = amillion + a million Average shares 4 million EPS = 1.66mn. umn = 0.416 on 41167 There is no improvement in EPS, as it is same as previous case' Note:

50% equity and son IPLANB Where he finances Deft. EBIT = 2.700,000 Lesson Interest @loy = (1,00,000) Lest Interest @ 101) = (5,00,000) son 5mn dollars) Less Tox note @ 2,100,000 (7,56,000) 367. EPS - 1,344.000 Net Income -Dividend Wegnled auuage shares ou branding Im tim 3 million shared = EP3 = 1,344,000 3,000,000 44.8 EPS = due to leverage In this case EPS has improved This plan has the higher eps - So we should take plan (6)

(A) EBIT Ondyperence point Equation & Ý -I) CI-T)-PD = (x-TJ (IT) where x = Point Indifference I - Inleret under allunotive Ig = Inleret under alternative T = Tax rate PD = Purjevence dividend si = Amount of equity under Ist alternative Sa Amount of Equily under and alternative I By Going by project where Interest (5mm x 10x) (x-1) C1-0.36) -0 = (x-0.5) (1-0:36)-0 -> (X-0) (064) = (x - 015) C0.64) .) - (x-0) 0.64 0.64 x O'64 x 0.32 0.32 = 2 (x-0.5) (0.64) 0 = 2x -0.5 0.64 = 1.28% - 0.32 1.28x - 0.641 0.64x EX 0.32 064 x =0.5 ties EBIT = 5,00,000

exuting Capital structure By company finanuale In the case we are taking and new copital structure - (X-I) (1-T)-PD (X-IQ) (1-T)-PD 3 * is on there It plan = (x-0.1) (1-0:36) (x=0.6) (1-0:36) 4 Under this interent are already poday Company 100,000 Commanw existing Interest but and plan 6,00,000 o tolas total interest - 3(x+0.120.64 = 4(4-06) 0.64 (3x - 03) 0.64 = (4x- 24) 0.64 1.998 - 0192 = 2.56x - 1.536 1.536 -0199 2.56 x - 1.98 134400 = 0.648 11344 064 = x x = 211m Indifference EBIT = 2.1 mn (Ans) point

PARTB Under Plon A) Less EBIT = Interest 2, You ooo C1,00,000) - 2,300,000 less Tax @367 = (8,28,000) Net profit = 1,472,000 EPS = Net prost - Dividend Weighted Average Ouestanding shares EPS - 1,472,000 4,DUDIDO O EPS = 0.368 (Under Plan B) EBIT = 2,409000 Les gut - (69000) (100,000 +500,000) PBT = 1,800,000 Les Tax = (648,000) Net prost = 1, 152,000 EPS = 1,1521000 3,000,000 = 0.384 Ans: We should take plan (13) as in the Care Eps in mereasing due to leverage