Lassiter Bakery currently has 3 million shares of common stock outstanding that sell at a price of $25 per share. Lassiter also has $10 million of bank debt outstanding at a pretax interest rate of 12 percent and a private placement of $20 million in bonds at a pretax interest rate of 14 percent. Lassiter’s marginal tax rate is 40 percent. Lassiter is planning entry into a new market area. This project will require Lassiter to raise $30 million. Two alternatives have been proposed:
Plan 1: Common equity financing. Sell new stock at a net proceeds price to Lassiter of $20 per share.
Plan 2: Debt-equity financing. Sell a combination of stock at a net proceeds price to Lassiter of $20 per share and $10 million of long-term debt at a pretax interest rate of 15 percent.
a. Compute the indifference level of EBIT between these two alternatives.
b. If Lassiter’s EBIT next year is approximately normally distributed with an expected value of $20 million and a standard deviation of $5 million, what is the probability that Plan 2 will result in higher earnings per share than Plan 1?