Cybernauts, Ltd., is a new firm that wishes to determine an appropriate capital structure. It can issue 16 percent debt or 15 percent preferred stock.
The total capitalization of the company will be $5 million, and common stock can be sold at $20 per share.
The company is expected to have a 50 percent tax rate (federal plus state).
Four possible capital structures being considered are as follows:
PLAN DEBT PREFERRED EQUITY
1 0% 0% 100%
2 30 0 70
3 50 0 50
4 50 20 30
a. Construct an EBIT-EPS chart for the four plans. (EBIT is expected to be $1 million.) Be sure to identify the relevant indifference points and determine the horizontal-axis intercepts.
b. Using Eq. (16.12), verify the indifference point on your graph between plans 1 and 3 and between plans 3 and 4.
c. Compute the degree of financial leverage (DFL) for each alternative at an expected EBIT level of $1 million.
d. Which plan is best? Why?