You're a financial analyst at Pinkerton Interactive Graphic Systems (PIGS), a successful entrant in a new and rapidly growing field. As in most new fields, however, rapid growth is anything but ensured, and PIGS's future performance is uncertain.
The firm expects to earn operating profits of $4 million next year, up from $1 million last year. To support this enormous growth the firm plans to raise $15 mil- lion in new capital. It already has capital of $5 million that is 40% debt.
PIGS can raise the new money in any proportion of debt and equity manage- ment chooses. The CFO is considering three possibilities: all equity, $8 million debt and $7 million equity, and all debt.
Interest on the current debt as well as on new borrowing is expected to be 10%, and the company pays state and federal income taxes at a combined rate of 40%. Equity will be raised by selling stock at the current market price of $10, which is equal to its book value.
The CFO has asked you to prepare an analysis to aid management in making the debt/equity decision. You are also to provide a recommendation of your own.
a. Prepare an EBIT-EPS analysis of the situation showing a line for the capital structure that results from each of the three options. (Calculate EPS under each new capital structure at EBIT levels of $1 million, $2 million, and $4 million. Then graph EBIT versus EPS for each option. Refer to Figure 14.3. Show last year's EPS on the graph.)
b. Discuss the effect the options might have on stock price.
c. Make a subjective recommendation under each of the following assumptions about the $4 million operating profit forecast. Support your position with words and references to your EBIT-EPS analysis.
1. The $4 million operating profit projection is a best-case scenario. Anything from ($2) million to $4 million has an equal probability of occurring.
2. The $4 million is a fair estimate with about a 60% probability. However, per- formance better than $4 million is unlikely. Results could range anywhere from zero to $4 million.
3. The $4 million is an easy target. There's an even chance of anything between $4 million and $8 million.