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 been proposed.
Plan A is an all-common-equity structure in which 2.5 million dollars would be raised by selling 82,000 shares of common stock.
Plan B would involve issuing 1.3 million dollars in long term bonds with an effective interest rate of 12.2% plus a 1.2 million would be raised by selling 41,000 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 firms 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:
A. Find the EBIT indifference level associated with the two financing plans.
B. 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 Plan B is chosen