Two inventive entrepreneurs have interested a group of venture capitalists in backing a new business project. The proposed plan would consist of a series of international retail outlets to distribute and service a full line of ingenious home garden tools. The stores would be located in high- traffic cities in Latin America such as Panama City, Bogotá, São Paulo, and Buenos Aires. Two financing plans have been proposed by the entrepreneurs. Plan A is an all common- equity structure. Five million dollars would be raised by selling 160,000 shares of common stock. Plan B would involve the use of long- term debt financing. Three million dollars would be raised by marketing bonds with an effective interest rate of 14 percent. Under the alternative, another $ 2 million would be raised by selling 64,000 shares of common stock. With both plans, $ 5 million is needed to launch the new firm’s operations. The debt funds raised under plan B are considered to have no fixed maturity date, because this portion of financial leverage is thought to be a permanent part of the company’s capital structure. The two promising entrepreneurs have decided to use a 35 percent tax rate in their analysis, and they have hired you on a consulting basis to do the following:
a. Find the EBIT indifference level associated with the two financing proposals.
b. Prepare income statements for the two plans that prove EPS will be the same regardless of the plan chosen at the EBIT level found in part (a).