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. $1 million would be raised by selling 200,000 shares at $5 each. Plan B would involve the use of financial leverage. $800,000 would be raised issuing bonds with an effective interest rate of 15% (per annum). Under this second plan, the remaining $200,000 would be raised by selling 40,000 shares at $5 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 30% tax rate is appropriate for the analysis. REQUIRED: a) Find the EBIT indifference level associated with the two financing plans using an EBIT-EPS graph. Check your results algebraically. b) A detailed financial analysis of the firm's prospects suggests that the long-term earnings before interest and taxes (EBIT) will be $100,000 annually. Taking this into consideration, which plan will generate the higher earnings per share (EPS)? c) Briefly explain the primary weakness of EBIT-EPS analysis as a financing decision tool.

Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
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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. $1 million would be raised by selling
200,000 shares at $5 each.
Plan B would involve the use of financial leverage. $800,000 would be raised issuing bonds with an
effective interest rate of 15% (per annum). Under this second plan, the remaining $200,000 would be
raised by selling 40,000 shares at $5 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 30%
tax rate is appropriate for the analysis.
REQUIRED:
a) Find the EBIT indifference level associated with the two financing plans using an EBIT-EPS
graph. Check your results algebraically.
b) A detailed financial analysis of the firm's prospects suggests that the long-term earnings before
interest and taxes (EBIT) will be $100,000 annually. Taking this into consideration, which plan
will generate the higher earnings per share (EPS)?
c) Briefly explain the primary weakness of EBIT-EPS analysis as a financing decision tool.
Transcribed Image Text: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. $1 million would be raised by selling 200,000 shares at $5 each. Plan B would involve the use of financial leverage. $800,000 would be raised issuing bonds with an effective interest rate of 15% (per annum). Under this second plan, the remaining $200,000 would be raised by selling 40,000 shares at $5 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 30% tax rate is appropriate for the analysis. REQUIRED: a) Find the EBIT indifference level associated with the two financing plans using an EBIT-EPS graph. Check your results algebraically. b) A detailed financial analysis of the firm's prospects suggests that the long-term earnings before interest and taxes (EBIT) will be $100,000 annually. Taking this into consideration, which plan will generate the higher earnings per share (EPS)? c) Briefly explain the primary weakness of EBIT-EPS analysis as a financing decision tool.
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