Question

 Abe Forrester and three of his friends from college have interested a group of 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 $2.4 million dollars would be raised by selling 90,000 shares of common stock.

•  Plan B would involve issuing $1.3 million in​ long-term bonds with an effective interest rate of 11.7 percent plus another $ 1.1 million would be raised by selling 45,000 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 38 percent tax rate in their​ analysis, and they have hired you on a consulting basis to do the​ following:

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

b.  Prepare a pro forma income statement for the EBIT level solved for in part a that shows that EPS will be the same regardless whether Plan A or B is chosen.

Answer 1

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