Question

Roberts, Inc. is trying to decide how best to finance a proposed $20 million capital investment. Under Plan I, the project will be financed entirely with long-term 9% bonds. The firm currently has no debt or preferred stock. Under Plan II, common stock will be sold to net the firm $20 a share; presently, 1 million shares are outstanding. The corporate tax rate for Roberts is 40%.

1.). Calculate the indifference level of EBIT associated with the two financing plan

2.)Which financing plan would you expect to cause the greatest change in EPS relative to a change in EBIT? Explain your reasoning

3.)If EBIT is expected to be $3.0 million, which plan will result in a higher EPS?

Answer 1

1) Indifference Level of EBIT: Indifferent point/level is that EBIT level at which the Earnings Per Share (EPS) is the same for two alternative financial plans.

The point of indifference can be calculated using the following formula:

{(X - Interest) ( 1- Tax )} / Number of Equity shares outstanding =  {(X ( 1- Tax )} / Number of Equity shares outstanding

So in this Case,

Number of Equity Shares outstanding 1 million i.e. 1,000,000
and number of shares issues $20 million / $20 = 1,000,000 shares
+ outstanding shares ( 1,000,000 )
= 2,000,000
Let us Assume X as the EBIT ;

; { ( X - 1,800,000 ) ( 1 - 0.40 ) } / 1,000,000 = { X ( 1 - 0.40 ) } / 2,000,000
; { ( X - 1,800,000 ) ( 0.60 ) } / 1,000,000 = { X ( 0.60) } / 2,000,000
; { 0.6X - 1,080,000 } / 1,000,000 = 0.60 X / 2,000,000
; 0.6X - 1,080,000 = 0.60X / 2
; 2 * ( 0.6X - 1,080,000 ) = 0.60X
; 1.2X - 2,160,000 = 0.60X
; 1.2X - 0.60X = 2,160,000
; 0.6X = 2,160,000
; X = 3,600,000

Indifference Level of EBIT of both the project is $ 3,600,000

2) The way in which EPS respond to change in EBIT depends on :
a] Fixed Financing Cost : A firm with no fixed finance cost has no financial leverage which means EPS will rise and fall with EBIT by same percentage.
Just in this Case, in project 2 firm is having no fixed financing cost which will lead to same EBIT=EBT
b] Some Fixed Financing Cost ; A firm having fixed financing cost will have some financial leverage which means EPS will rise and fall with by a greater percentage .
Just in this Case, in project 1 firm is having 9% debt which will lead to greatest change in EPS as compared to project 2.

Since EPS will be the same at the indiffernce level of EBIT , Project 1 will cause greatest change in EPS relative to change in EBIT due to its Financial Leverage.

3) Expected EBIT is $ 3 million or 3,000,000

then higher EPS will be of :

Particulars	Plan1	Plan 2
EBIT	3,000,000	3,000,000
- Interest	(1,800,000 )	0
EBT	1,200,000	3,000,000
- Tax @ 40%	480,000	1,200,000
EAT	720,000	1,800,000
Number of Equity Shares	1,000,000	2,000,000
EPS	0.72	0.9

Plan 2 is having high EPS of 0.9