Abe Forrester and three of his friends from college have interested a group fo v

Question

Abe Forrester and three of his friends from college have interested a group fo venture capitalists in backing their business idea. The proposed operation would consist of a series of retail outlets to distribute and service a full line of vacuum cleaners and accessories. These stores would be located in Dallas, Houston, and San Antonia. To finance the new venture two plans have been proposed:

Plan A is an all common equity structure in which $2.5 million dollars would be raised by selling 82,000 shares of common stock.

Plan B would involve issuing $1.3 million dollars in long term bonds with an effective interest rate of 12.5% plus $1.2 million would be raised by selling 41,000 shares of common stock. The debt funds raised under plan B have no fixed maturity date, in that this amount of financial leverage is considered a permanent part of the firms capital structure.

Abe and his partners plan to use a 40% tax rate in their analysis, and they have hired you on a consulting basis to do the following:A.

1. Find the EBIT indifference level associated with the two financing plans. The EBIT indifference level associated with the two financing plans is $__________ (round to the nearest dollar)

Explanation / Answer

EPS of plan A   = EPS of plan B

[EBIT(1-Tax)] /Number of shares in plan A = [(EBIT -Interest)(1-Tax)]/Number of shares.

[EBIT(1-.40)]/82000      = [(EBIT-162500)(1-.40)]/41000

EBIT(.60)/82000 =   [(EBIT-162500)(.60)]/41000

.60EBIT /82000 = [.60EBIT -97500]/41000

Or since 82000 is divisible by 41000 by 2

therefore It looks like:

.60EBIT/2 = [.60EBIT-97500]

.60EBIT= 2[.60EBIT-97500]

.60EBIT=1.2 EBIT-195000

.1.2EBIT-.60EBIT = 195000

.60 EBIT= 195000

EBIT=195000/.60

        = $ 325,000

So at EBIT equals 325000 , you will be indifferent between two financing plans

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