4.

Emco Products has a present capital structure consisting only of common stock (10
million shares). The company is planning a major expansion. At this time, the company is
undecided between the following two financial plans (assume a 40 percent marginal tax
rate):

Plan 1 (Equity financing). Under this plan, an additional 5 million shares of

common stock will be sold at $10 each.

Plan 2 (Debt financing). Under this plan, $50 million of 10 percent long term debt
will be sold.

One piece of information the company desires for its decision analysis is an EBIT-EPS
analysis.

a. Calculate the EBIT-EPS indifference point.

Interest under Debt Alternative = $50 (million) 10% = $5 (million)

EPS (debt financing) = EPS (equity financing)

(EBIT - Interest)(1-Tax Rate) (EBIT)(1-Tax Rate)

=
Number of CS Shares Outstanding Under Debt Alt. Number of CS Shares Outstanding Under Equity A

(EBIT - 5)(0.6) (EBIT)(0.6)

=
10 15

0.6 EBIT - 3 0.6 EBIT

=
10 15

(10)(0.6 EBIT ) = (15)(0.6 EBIT - 3)

6EBIT = 9EBIT - 45

3 EBIT = 45

EBIT = $15

B.Graphically determine the EBIT-EPS indifference point

Hint: Use EBIT = $10 million and $25 million.

Please see the attached excel sheet for calculations

c. What happens to the indifference point if the interest rate on debt increases and the
common stock sales price remains constant?

Indifference point moves to right, i.e., higher EBIT

d. What happens to the indifference point if the interest rate on debt remains constant and
the common stock sales prices increases?

Indifference point moves to right, i.e., higher EBIT.

5. Morton Industries is considering opening a new subsidiary in Boston, to be operated as

a separate company. The companys financial analysts expect the new facilitys average
EBIT level to be $6 million per year. At this time, the company is considering the
following two financing plans (use a 40 percent marginal tax rate in your analysis):

Plan 1 (Equity Financing). Under this plan, $2 million common shares will be
sold at $10 each.
Plan 2 (Debt equity financing). Under this plan, $10 million of 12 percent long-
term debt and 1 million common shares at $10 each will be sold.

a. Calculate the EBIT-EPS indifference point.

EPS (Plan 1) = EPS (Plan 2)

[(EBIT - 0)(1 - .4)]/2 = [(EBIT - 1.2)(1 - .4)]/1

EBIT* = $2.4 million

b. Calculate the expected EPS for both financing plans.

Plan 1 Plan 2

EBIT $6.0 $6.0

I 0 1.2

EBT $6.0 $4.8

T @ 40% 2.4 1.92

EAT $3.6 $2.88

Shares Outstanding 2.0 1.0

EPS $1.80 $2.88

c. What factors should the company consider in deciding which financing plan to adopt?

The factors the company should consider include the following:

1. The plan's effect on the company's stock price (difficult to determine in practice).

2. The capital structure of the parent company.

3. The probability distribution of expected EBIT.

d. Which plan do you recommend the company adopt?

Adopt plan 2 if the company can be reasonably sure that EBIT will not drop too much in

a recession. Otherwise, plan 1 appears better.

e. Suppose Morton adopts Plan 2, and the Boston facility initially operates at an annual
EBIT level of $6 million. What is the times interest earned ratio?

T.I.E. = (EBIT/I) = (6.0/1.2) = 5 times

Note: This calculation assumes no short-term debt, either permanent or seasonal.

6. Moon and Chittenden are considering a new Internet venture to sell used textbooks.
The project requires $300,000 in financing. Two alternatives have been proposed.

Plan 1 (Common equity financing). Sell 30, 000 shares of stock at a net price of
$10 per share.
Plan 2 (Debt equity financing). Sell a combination of 15,000 shares of stock at a
net price of $10 per share and $150,000 of long-term debt at a pretax interest rate of 12
percent.

Assume the corporate tax rate is 40 percent.

a. Compute the indifference level of EBIT between these two alternatives

Plan A
Debt= $0
Equity= $300,000
# of shares= 30,000
Interest rate= 12.00%
Interest expense= $0.00

Plan B
Debt= $150,000
Equity= $150,000
# of shares= 15,000
Interest rate= 12.00%
Interest expense= $18,000 =12.% x $150,000.
EPS = (EBIT - Interest)x (1-Tax rate) / # of shares

EPS
Plan A : (EBIT-0) (1-0.4)/30000
Plan B : (EBIT-18000) (1-0.4)/15000
For point of indifference EPS under two plans should be eaual
or
(EBIT-0) (1-0.4)/30000 = (EBIT-18000) (1-0.4)/15000

Solving for EBIT:

EBIT= $36,000

Answer: EBIT= $36,000

b. If the firms EBIT next year has an expected value of $25,000, which plan would you
recommend assuming maximizing EPS is a valid objective?

Below the indifference point, the plan with lower debt is better
Hence opt for Plan A as it would give a higher EPS

Check:

EBIT= $25,000
Plan A
Debt $0

Earnings before interest and taxes (EBIT) . . . . . . . . . . . . . . . . . 25,000

Less Interest expense @ 12.00% 0 =12.% x $.
Earnings before taxes (EBT) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000
Less Taxes @ 40% 10,000 =40.% x $25,000.
Net Income= 15,000

Number of shares= 30,000

EPS= $0.500 =$15,000. / 30,000.

Plan B
Debt $150,000

Earnings before interest and taxes (EBIT) . . . . . . . . . . . . . . . . . 25,000

Less Interest expense @ 12.00% 18,000 =12.% x $150,000.
Earnings before taxes (EBT) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000
Less Taxes @ 40% 2,800 =40.% x $7,000.
Net Income= 4,200
Number of shares= 15,000
EPS= $0.280 =$4,200. / 15,000.