Four investors are in the process of forming a new company. The new firm will produce and
Question:
Four investors are in the process of forming a new company. The new firm will produce and distribute computer hardware on a national basis. The hardware will be aimed at scientific markets and at businesses desiring to install comprehensive information systems. Private investors have been sourced to finance the new company.
Two financing proposals are being considered. Both these plans involve the use of some financial leverage; however, one is much more highly levered than the other plan. Plan A requires the firm to sell bonds with an effective interest rate of 10%. One million dollars would be required in this manner. In addition, under plan A, $5 million will be raised by selling 1million shares.
Plan B also involves raising $6 million. This would be accomplished by raising $1 million from selling ordinary shares at the same price as in plan A. $5 million will be raised by selling bonds with an effective interest rate of 12%. In both cases the use of financial leverage is considered to be a permanent part of the firm's capital structure, so no fixed maturity date is used in the analysis. The firm considers a 30% tax rate to be appropriate for planning purposes.
Required:
Find the EBIT indifference level associated with the two financing plans.