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 bee proposed:
Plan A is an all-common-equity structure in which $2.4 million dollars would be raised by selling 80,000 shares of common stock.
Plan B would involve issuing $1.2 million in long-term bonds with an effective interest rate of 11.9 percent plus another $1.2 million would be raised by selling 40,000 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% tax rate in their analysis, and they have hired you on a consulting basis to do the following:
- Find the EBIT indifference level associated with the two financing plans.
- 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.