Two Financing Plans (Please Help)

Question

Moon and Chittenden are considering a new Internet venture to sell used textbooks. The project requires $300,000 in financing. Two alternatives have been proposed.

Plan 1 (Common equity financing). Sell 30,000 shares of stock at a net price of $10 per share.

Plan 2 (Debt equity financing). Sell a combination of 15,000 shares of stock at a net price of $10 per share and $150,000 of long-term debt at a pretax interest rate of 12 percent.

Assume the corporate tax rate is 40 percent.

A. Compute the indifference level of EBIT between these two alternatives

B. If the firm’s EBIT next year has an expected value of $25,000, which plan would you recommend assuming maximizing EPS is a valid objective?

Answer 1

I majored in finance, but don't remember doing indifference curves, but they strike me as just breakeven points basically.  

so since plan 1 give you EPS of $0.5.  then you need EBIT of $30,500 in option 2 to result in EPS of $0.5.  b/c:

$30,500 minus $18,000 int expense = $12,500.  applying taxes gives you $7,500 in earnings.  divided by 15,0000 shares outstanding gives you $0.5 EPS.   is this right?

for B.  i would recommend issuing the stock, which makes your EBIT = your EBT, so aftertax income is (1 - tax rate) * $25K.   so $15K / 30,000 shares outstanding give you EPS = $0.5 per share.

option 2 results in pretax incomne of $7K, or $4.2 aftertax, which divided by 15,000 shares outstanding gives you EPS of $0.3.   so option 1 is best.