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# Financial Statements under Two Financing Alternatives

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Calculate and complete the boxes noted with "?". Make a recommendation of one of the two options. Why do you believe the selected option is preferred over the other? Would their be additional information that you might with to have to support your decision? If so, what? Which alternative carries a higher risk. Review colleagues postings and comment on their choices.

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Activity 2

Assume you are about to start a new company. Let's call it Super Health, Inc. The business requires \$200,000 in assets to get into operation, and there are only two financing alternatives available to you are 1) all equity (all common stock) and 2) 50 percent equity and 50 percent debt.
Following is the business's projected financial statements under the two financing alternatives. The business will require \$100,000 in current assets and \$100,000 in fixed assets to begin operations.
Since the asset requirement depends upon on the nature and size of the business rather than on how the business will be financed, the assets side of the balance sheet is unaffected by the financing schemes. However, the capital, or claims side, is influenced by the type of financing.
Under the all equity alternative, you will put up the entire \$200,000 needed to purchase the assets. If 50 percent debt financing is used, you will contribute only \$100,000 of your own funds and the remaining \$100,000 will be obtained from creditors, say, a bank loan at 10 percent interest rate. Your task is to complete all of the ? spaces and make a recommendation regarding which financing alternative to select and why for DQ #2?
Super Health, Inc: projected Financial Statements under Two Financing Alternatives
Stock Stock/Debt
Balance Sheet
Current Assets \$100,000 \$100,000
Fixed ...

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This discusses the projected Financial Statements under Two Financing Alternatives

\$2.19

## Cost Effectiveness and Analytical Income Statements

1. Given the following data for El Pollo Loco Inc:

Percent of capital structure:
Debt 35%
Preferred stock 10%
Common equity 55%

Bond coupon rate 11%
Bond yield to maturity 9%
Dividend, expected common \$ 2.50
Dividend, preferred \$ 7.00
Price, common \$ 45.00
Price preferred \$100.00
Flotation costs, preferred \$ 5.00
Growth rate 8%
Corporate tax rate 35%

a) Calculate its weighted average cost of capital (WACC).

b) What would be the WACC for Pollo Loco Inc. if the tax corporate rate increases to 45%?

c) What are the implications of the changes in part B) for investing in capital projects?

2. In general terms, why is the effective cost (cost to company) of debt less than the cost of common stock if both securities are priced to yield (return to the investor) 10 percent in the market?

3. (EBIT-EPS analysis) A group of graduates have decided to form a small manufacturing corporation. The company will produce a full line of traditional office furniture. Two financing plans have been proposed by the investors. Plan A is an all-common-equity alternative. Under this agreement, 1 million common shares will be sold to net the firm \$20 per share. Plan B involves the use of financial leverage. A debt issue with a 20-year maturity period will be privately placed. The debt issue will carry an interest rate of 10 percent, and the principal borrowed will amount to \$6 million. Under this alternative, another \$14 million would be raised by selling 700,000 shares of common stock. The corporate tax rate is 50 percent.

a) Find the EBIT indifference level associated with the two financing proposals.

b) Prepare an analytical income statement that proves EPS will be the same regardless of the plan chosen at the EBIT level found in part (a).

c) Prepare an EBIT-EPS analysis chart for this situation.

d) If a detailed financial analysis projects that long-term EBIT will always be close to \$1,800,000 annually, which plan will provide for the higher EPS?

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