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EBIT-EPS analysis

Two recent graduates open a compute shop and incorporate in several states. Eight prospects for retail outlets have already been identified in these states. They are ready for business, all that is lacking is adequate financing to continue the project. A small group of private investors are interested in financing the company. Two proposals are being evaluated. Plan A is an all common equity capital structure. Three million dollars will be raised by selling stock at $40 per common share. Plan B would involve the use of financial leverage. One million dollars would be raised by selling bonds with an effective tax rate of 14 percent (per annum). Under the second plan, the remaining$2 million would be raised by selling common stock at the $40 price per share. The use of financial leverage is considered to be permanent part of the firm's capitalization, so no fixed maturity date is needed for analysis. A 50 percent tax rate is appropriate for the analysis.

Question 1: prepare an analytical income statement that proves EPS will be the same regardless of the plan chosen at the EBIT level found from the EBIT difference of the two plans.

Question 2: A detailed financial analysis of the firms prospects, suggests that the long term EBIT will be above $750,000 annually. Taking this into consideration, which plan will generate the higher EPS.

What I need help with is the formula and run down of the process to figure out this problem, the explicit answer is not necessary.

Solution Preview

We first calculate the EBIT where the EPS is the same.
EPS = Net Income/Number of Shares = (EBIT-Interest)*(-tax rate)/Number of Shares.
Option 1 - The number of shares are 3,000,000/40=75,000 and there is no interest.
EPS = EBIT *(1-tax rate)/75,000
Option 2 - The number of shares are 2,000,000/40=50,000. There will ...

Solution Summary

The solution explains how to carry out a EBIT-EPS analysis.