Abe Forrester and three of his friends from college have interested a group fo v
ID: 2722563 • Letter: A
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 Antonio. To finance the new venture two plans have been proposed. Plan A is an all-common equity structure in which $2.1 million dollars would be raised by selling 84,000 shares of common stock. Plan B would involve issuing $1.1 million in long-term bonds with an effective interest rate of 12.3 percent plus another $1.0 million would be raised by selling 42,000 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 firm's capital structure. Abe and his partners plan to use a 34 percent tax rate in their analysis and they have hired you on a consulting basis to find the EBIT indifference level associated with the two financing plans. What is the EBIT indifference level associated with the two financing plans?
Explanation / Answer
Abe Forrester Venture Capital All Amounts in $ The EBIT indifference level associated with two financing plans Plan 1 Finance through fully backed equity of $ 2.1 million dollars Plan 2 Finance through $ 1.1 million in long term bonds with an effective interest rate of 12.3 percent Balance $ 1 million through issue of common stock The EBIT indifference level between these two plans will be equal to the after tax cost of interest on the long term bonds, since the balance is being raised through common stock in both the plans Thus, the EBIT Difference will be calculated as 66% of (12.3% of $ 1.1 million) = 0.09 million $ OR 89298 $