Question

1. Big Bob Corporation has a present capital structure consisting of common stock (10 million shares) and debt ($140 million, 6% coupon rate). The company needs to raise $46 million and is undecided between two financing plans.  Plan A: Equity financing. Under this plan, an additional common stock will be sold at $15 per share.  Plan B: Debt financing. Under this plan, the firm will issue 10% coupon bonds.  At what level of operating income (EBIT) will the firm be indifferent between the two plans? Assume a 40% marginal tax rate.

Answer 1

	Big Bob Corporation
	At the indifferent EBIT , the EPS for both the options will be
	the same.We assume the indifferent EBIT is x
	Particulars	Plan A	Plan B
	Beginning no of outstanding common stocks	10,000,000	10,000,000
	New Equity price /share	15	-
	Amount of Equity Raised	46,000,000	-
	No of Additional shares to be issued =$46M/$15=	3,066,667	-
a	Total No of outstanding stocks after Capital Increase	13,066,667	10,000,000
	Debt Value before additional capital raising	140,000,000	140,000,000
	Annual Interest @6%	8,400,000	8,400,000
	Additional Debt raised	-	46,000,000
	Additional Interest payable@10%	-	4,600,000
b	Total Interest Expense /year	8,400,000	13,000,000
	Now Indifferent EBIT	x	x
	Less Interest	8,400,000	13,000,000
	EBT	(x-8,400,000)	(x-13,000,000)
	Tax @40%	(x-8,400,000)*0.4	(x-13,000,000)*0.4
	After Tax income	(x-8,400,000)*0.6	(x-13,000,000)*0.6
	Commom Shares Outstanding	13,066,667	10,000,000
	EPS =	(x-8,400,000)*0.6/13066667	(x-13,000,000)*0.6/10000000
	Now for Indifferent EBIT , EPS will be same under both options
	Therefore , (x-8,400,000)*0.6/13066667 =(x-13,000,000)*0.6/10000000
	x=28,000,000
	So, The Indifferent EBIT between two plans =$28,000,000