Two different financing Plans (HELP PLEASE)

Question

Emco Products has a present capital structure consisting only of common stock (10 million shares). The company is undecided between the following two financing plans (assume a 40 percent marginal tax rate):

Plan 1 (Equity Financing) Under this plan, and additional 5 million shares of common stock will be sold at $10 each.

Plan 2 (Debt Financing) Under this plan, $50 million of 10 percent long-term debt will be sold.

One peice of inforamtion the comapny desires for its decision analysis is an EBIT-EPS analysis.

A. Calculate the EBIT-EPS indifference point.

B. Graphically determine the EBIT-EPS indifference point.

Hint: Use EBIT = $10 million and $25 milion

C. What happens to the indifference point if the interest rate on debt increases and the common stock sales price remains constant?

D. What happens to the indifference point if the interest rate on debt remains constant and the common stock sales price increases?

Answer 1

Kristen: At some point you should be able to use the information in answers from your previous questions to figure out some of these new questions. Else I think we may be doing a tremendous injustice to your ability to learn by solving these problems for you. Nevertheless, here goes:

A. EPS(A) = EPS(B)

(EBIT - I(A))*(1-t)/N(A) = (EBIT - I(B))*(1-t)/N(B)

(EBIT - 0)*(1-0.4)/15 = (EBIT-(0.1*50))*(1-0.4)/10

0.04*EBIT = 0.06*EBIT - 0.3

EBIT = 0.3/0.02 = $15m

B. Cannot be done here - but use the EBIT/EPS equation to solve for EPS using two different values for EBIT ($10m & $25m) for the two plans. You will see that the Plan A and Plan B will intersect at EBIT = $15m

C. & D.) Both these can be solved by observing the equivalency form question A or solving the equations using excel.

In case of question C.: As the interest rate increases, the EPS in Plan B will decrease because more of the EBIT will go towards satisfying the increased interest requirements. Hence the EBIT (i.e. the indifference point) will have to increase to meet the new interest requirements. As an example, if interest rate increases, the new EBIT (indifference point) would be $18m which translates to a EPS of $0.72 in both Plan A and Plan B. (Use the equation in Question A to solve for this scenario)

In case of question D: As the common stock sale price increases, the no. of shares to be sold to raise $50m will decrease. This would mean a higher EPS no. for the Plan A if the EBIT remains constant. Hence again the EBIT in this case has to increase if the Plan B has to be equally as profitable as Plan A.