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%

Additional Information:
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?