Quality Lumber is planning a major expansion program requiring $5,000,000 in financing. Quality may sell bonds with an 8% coupon rate or sell 200,000 shares of common stock to get the needed funds. After the expansion there is a 30% probability of EBIT (Earnings Before Interest and Taxes) being $2 million, a 50% probability of it being $3 million and a 20% probability of it being $4 million. The following data was taken from the firm’s pre-expansion income statement: Interest expense $100,000 Tax Rate 40% Common shares outstanding 300,000

a) Calculate the EPS based on the expected EBIT under each alternative.

Expected EBIT= 0.3*2+0.5*3+0.2*4= $2.9 million; Interest = $100,000= $0.1 million ; Actual EPS = 2.9-0.1= $2.8 million; After tax EPS= 2.8(1-0.4)= $1.68 million

EPS for under share issue= 1.68/(0.2+0.3)=$3.35/share

EPS when bonds are issued= 2.9- 0.1= $2.8 million. Additional interest = 0.08*5,000,000= 400,000= $0.4million. After tax EPS= (2.8-0.4)*(1-0.4)= $1.44 million so EPS = 1.44/ 0.3= $4.8/share

Which plan would you chose at this level of EBIT?

I will chose the plan when bond are issued. EPS = $4.8/share.

Compute the DFL (Degree of Financial Leverage) under each financing alternative. If EBIT increased by 10%, what would the new EPS be under each alternative?

DFL =EBIT/ (EBIT- interest)

DFL under share issue = 2.9/2.8= 1.03

DFL under bond issue= 2.9/2.4= 1.21

1) Calculate the indifference EBIT if instead of issuing 200,000 shares of common stock to raise the funds (the second option), the company issues 100,000 common shares and 100,000, $50 par, 3% preferred shares.