Problem:
Four recent liberal arts graduates have interested a group of venture capitalists in backing a new business enterprise. The proposed operation would consist of a series of retail outlets to distibute and service a fuul line of vacuum cleaners and accessories. These stores will be located in Dallas, Houston, and San Antonio. Two financing plans have been proposed by the graduates. Plan A is an all-common-equity structure.Two million dollars would be raised by selling 100,000 shares of common stock. Plan B would involve the use of long-term debt financing. One million dollars would be raised by marketing bonds with an effective interest rate of 8 percent. Under this alternative, another $1 million would be raised by selling 50,000 shares of common stock. With both plans, then, $2 million is needed to launch the new firm's operations. The debt funds raised under plan B are considered to have no fixed maturity date, in that this portion of financial leverage is thought to be a permanent part of the company's capital structure. The fledgling executives have decided to use a 30 percent 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 proposals.
B) Prepare an income statement that proves EPS will be the same regardless of the plan chosen at the EBIT level found in part a.