Question

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B15-13 (book/static) : Question Help O (EBIT-EPS analysis) 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 $ . (Round to the nearest dollar.)

Answer 1

a. No of shares with plan A = 2,000,000 / 20 = 100,000 shares

No of shares as per Plan B = 1,000,000 / 20 = 50,000 shares

Interest on the bond issue = 1,000,000 *11% = 110,000

Equating both EBIT's:

( EBIT ) * ( 1 -30%) / 100,000 = ( EBIT - 110,000) (1-0.3) / 50,000

EBIT / 2 = EBIT - 110,000

EBIT = 220,000

The EBIT indifference level associated with the two financing plans is $220,000

b. EPS under Plan A = ( 300,000) * (1-30%) / 100,000 = 2.1

EPS under Plan B = ( 300,000 -110,000) * (1-30%) / 50,000 = 2.66

Plan B will generate a higher EPS.