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.
b.Graphically determine the EBIT-EPS indifference point
Hint:Use EBIT = $10 million and $25 milliion.
c. What happens to the indifference point if the interest rate on debt increases and the common stock sales price remains constant?
d. What happens to the indifference point if the interest rate on debt remains constant and the common stock sales prices increases?
Please see response in the attached file.
Data (Figures in million $)
Plan 1 Plan 2
Current number of shares 10 10
New issue 5 0
No. of shares 15 10
Equity $50 0
Debt 0 $50
Interest rate 10% 10%
Interest $0.00 $5.00
Tax rate 40%
a . Calculate the EBIT-EPS indifference point.
((EBIT-Inertest expenses before tax as per plan 1)(1-Tax rate))/No. shares as per plan 1 =((EBIT-Inertest expenses before tax as per plan 2)(1-Tax rate))/No. shares as per plan 2
(EBIT -0)*(1-.4))/15 =((EBIT -5)*(1-.4))/10
0.6EBIT/15=0.6 EBIT -3
10*0.6 EBIT ...
For Emco Products, the solution examines two plans: one with equity and one with debt. The detailed calculations for EBIT-EPS include a graphic illustration of the indifference point in the decision analysis.