Question

You are investigating the expansion of your business and have sought out two avenues for the sourcing of funds for the expansion.

The first (Plan A) is an all-ordinary-share capital structure. $10 million would be raised by selling 100,000 shares at $100 each.

Plan B would involve the use of financial leverage. $1 million would be raised issuing bonds with an effective interest rate of 10% (per annum). Under this second plan, the remaining $9 million would be raised by selling 90,000 shares at $100 price per share. The use of financial leverage is considered to be a permanent part of the firm’s capitalisation, so no fixed maturity date is needed for the analysis.

A 25% tax rate is appropriate for the analysis.

REQUIRED:

1. Find the EBIT indifference level associated with the two financing plans using an EBIT–EPS graph. Provide a check of your calculation to prove the EBIT indifference level.
2. A detailed financial analysis of the firm’s prospects suggests that the long-term earnings before interest and taxes (EBIT) will be $1,500,000 annually. Taking this into consideration, which plan will generate the higher earnings per share (EPS)?

Rather than EBIT, you are interested in other measures of risk associated with a project.

The basic values for your company is as follows:

Total Fixed Costs: $500,000

Price per unit: $18

Costs per unit: $14

3. What is the accounting break-even point? What does this number represent?

Answer 1

Solution:

INdifference at 1000000

At $1,500,000, PLan B is better.

Excel solution is below. Data tables in excel are used.

c.

Breakevent point = 500,000/(18-14) = 125,000 units. At this point no profit no loss for company.

-x-