Question

(​EBIT-EPS analysis​) A group of retired college professors has decided to form a small manufacturing corporation. The company will produce a full line of traditional office furniture. The investors have proposed two financing plans. Plan A is an​ all-common-equity alternative. Under this​ agreement, 1.2 million common shares will be sold to net the firm $ 10 per share. Plan B involves the use of financial leverage. A debt issue with a​ 20-year maturity period will be privately placed. The debt issue will carry an interest rate of 13 ​percent, and the principal borrowed will amount to ​$3.6 million. The corporate tax rate is 46 percent.

***Please do not copy and paste answer from another question not using the numbers from this question as the last person did with my original submission of this question***

***Please Show All Work***

a. Find the EBIT indifference level associated with the two financing proposals.

b. Prepare an analytical income statement that proves EPS will be the same regardless of the plan chosen at the EBIT level found in part ​(a​).

c. Prepare an​ EBIT-EPS analysis chart for this situation.

d. If a detailed financial analysis projects that​ long-term EBIT will always be close to ​$2.06 million​ annually, which plan will provide for the higher​ EPS?

Answer 1

Ans 1. The level of EBIT at which both financial plan A and B of a manufacturing company intersect each other is called indifference point. At this point the EPS for both the plans are same. The indifference point can be calculated as under:

Suppose the indifference point exists at EBIT of X. At this point the EPS of both the financing plans would be same. Therefore, following equation-1 has to be satisfied.

X (1-t)/N1 = (X -Int)(1-t)/N2

Where: X – EBIT at which the indifference point exist

N1: number of equity shares in plan-A

N2: number of equity shares in plan-B

Int: Interest amount

t: tax rate

Putting the values of each of these variables in equation-1,

we will get: X (1-0.46)/12000000 = (X-468000)* (1-0.46)/8400000

X= $ 1560000

Therefore, the indifference point exists at EBIT of $ 1560000.

Working Note:

Here in plan-A we consider all equity option that equity is of $12000000 i.e. 1.2million*$10.

For plan B we consider $3.6 million as debt

Interest on debt is 13% of $3.6

And rest i.e.$ 12 million-$3.6=$8.4 as debt.

Ans 2 Income Statement

Particulars	Plan-A	Plan-B
EBIT	1560000	1560000
Less Interest on Loan	0	468000
EBT	1560000	1092000
Less tax	717600	502320
PAT	842400	589680
Equity Capital	12000000	840000
EPS	0.702	0.702