(EBIT-EPS analysis) A group of retired college professors has decided to form a small manufacturing corporation that will produce a full line of traditional office furniture.
The investors have proposed two financing plans:
Plan A is an all-common-equity alternative. Under this agreement, 1.6 million common shares will be sold to net the firm $10 per share.
Plan B involves the use of financial leverage. A debt issue with a 20-year maturity period will be privately placed.
The debt issue will carry an interest rate of 9 percent, and the principal borrowed will amount to $1.6 million.
The marginal corporate tax rate is 25 percent.
a. Find the EBIT indifference level associated with the two financing proposals.
b. Prepare a pro forma income statement that proves EPS will be the same regardless of the plan chosen at the EBIT level found in part a.
c. Prepare an EBIT-EPS analysis chart for this situation.
d. If a detailed financial analysis projects that long-term EBIT will always be close to $1.94 million annually, which plan will provide for the higher EPS?
e. If you were to present the results of your analysis found in part a through d, how would you summarize your findings to your employer?