Question

In: Finance

Eolop company now has an investment plan which needs $5m. The company has two financing proposals....

  1. Eolop company now has an investment plan which needs $5m. The company has two financing proposals. Plan A is to borrow $2m at 10% and $3m will need to sell stocks at $50 per common share. Plan B would involve higher financial leverage. $1m would be raised by selling bonds with an effective interest rate of 10% and the remaining $4 million would be raised by selling a common stock at the $50 price per share. The fixed operating cost will be $800,000. The corporate tax rate is 40%.

    1. Find the EBIT indifference level associated with the two financing plans.

    2. Prepare an analytical EBIT-EPS analysis chart for this situation.

    3. If a detailed financial analysis project that long-term EBIT will be in the range of $0.8m to $1m annually, which plan will generate higher EPS?

    4. Please calculate DOL, DFL, and DCL at the point of EBIT being $1 million under plan B.

    5. Please describe the meaning of DOL, DFL, and DCL.

Solutions

Expert Solution

Note - There appears to be one mis-statement in question. It Says " Plan B would involve higher financial leverage" But data given in question shows that plan B would have $1 million debt, ie. lesser financial leverage as compare to Plan A ($2 million Debt). So the question is answered ignoring this line.

The picture shows all the calculations along with the formulas

Part E

The OL shows by how much times the EBIT is expected to change if there is 1% change in Sales. For example if the Sales increase by 10% in the above plan B , the EBIT is expected to increase by 1.8 times of 10% ie. by 18%.

Similarly FL shows by how much times the EBT is expected to change if there is 1% change in EBIT. For example if the EBIT increase by 10% in the above plan B , the EBT is expected to increase by 1.1111 times of 10% ie. by 11.11%.

Similarly CL shows by how much times the EBT is expected to change if there is 1% change in Sales. For example if the Sales increase by 10% in the above plan B , the EBT is expected to increase by 2 times of 10% ie. by 20%.


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