Question

A group of graduate students has decided to form a small Internet Service Company in Brevard County. The company will service Brevard County Florida home users and need $400 million to start the company. Two financing plans have been proposed by the investment banking firms. Plan A is an all common- equity alternative. Under this agreement, 4 million common shares will be sold to net the firm $100 per share. Plan B involves the use of financial leverage (debt and equity). A debt issue with a 20-year maturity period will be privately placed. The debt issue will carry an interest rate of 10 percent, and the principal borrowed will amount to

$200 million. The corporate tax rate is 40 percent. If the detailed financial analysis

projects that there is a 30% chance that EBIT will be $15.0 million, 40% chance that it will be $18.0 million, and 30% chance that it will be $20 million annually, which plan will maximize the wealth of the stockholders? (note: the problem is based on the understanding of financial statement and financial leverage)

Plan ?

Answer 1

We will have to compare EPS & ROE under both the plans to find which plan maximizes shareholder wealth

Calculating EPS & ROE under Plan A

As there is no debt under Plan A, hence interest = 0

Net income when chance is 30% = (EBIT - Interest)(1-tax rate) = (15-0)(1-40%) = 15 x 60% = $9 million

Net income when chance is 40% = (EBIT - Interest)(1-tax rate) = (18-0)(1-40%) = 18 x 60% = $10.80 million

Net income when chance is 30% = (EBIT - Interest)(1-tax rate) = (20-0)(1-40%) = 20 x 60% = $12 million

Expected Net income =30% x Net income when chance is 30% + 40% x Net income when chance is 40% + 30% x Net income when chance is 30% = 30% x 9 + 40% x 10.80 + 30% x 12 = 2.70 + 4.32 + 3.60 = 10.62 million

Earnings per share = Expected net income / No of shares outstanding = 10.62 million / 4million = $2.655

Return on Equity = Expected net income / Total Equity = 10.62 million / 400 million = 2.655%

Calculating EPS & ROE under Plan B

Debt = $200 million   interest = Debt x interest rate = 200 x 10% = 20 million

Total Equity = Total capital raised - debt = 400 - 200 = $200 million

No of shares outstanding = Total Equity / Price per share = 200 million / 100 = 2 million

Net income when chance is 30% = (EBIT - Interest)(1-tax rate) = (15-20)(1-40%) = -5 x 60% = -$3 million

Net income when chance is 40% = (EBIT - Interest)(1-tax rate) = (18-20)(1-40%) = -2 x 60% = -$1.2 million

Net income when chance is 30% = (EBIT - Interest)(1-tax rate) = (20-20)(1-40%) = 0 x 60% = $0 million

Expected Net income =30% x Net income when chance is 30% + 40% x Net income when chance is 40% + 30% x Net income when chance is 30% = 30% x -3 + 40% x -1.2 + 30% x 0 = -0.9 - 0.48 + 0 = -1.38 million

Earnings per share = Expected net income / Shares outstanding = -1.38 million / 2 million = - 0.69

Return on Equity = Expected net income / Total Equity = -1.38 million / 200 million = -0.69%

As can be seen the EPS & ROE under plan A is positive, hence they increase the shareholder wealth. On the other hand EPS and ROE under plan B are negative., therefore decrease the shareholder wealth. Hence Plan A maximizes shareholder wealth

Answer: Plan A