General Energy Storage Systems: How Much Debt and How Much Equity? General Energy Storage Systems (GESS) was founded in 2002 by Ian Redoks, a PhD. Candidate in physics who was interested in "outside - the - box" solutions to the problem of storing electrical energy. Redoks had obtained several patents with potential applications for plug-in hybrid cars, of- grid home electrical systems, and large - scale storage of commercial electricity, produced by conventional means from excess capacity at off-peak hours or from non-fossil-fuel sources such as solar power and wind power. The timeliness of Redoks' has quickly attracted investors. For example, GESS has own contracts from an automobile company to manufacture batteries for a limited production plug-in hybrid. It is also ready to begin commercial production of storage components for grid home electrical systems. More products mean more storage space, however. To acquire the necessary manufacturing facilities, GESS needs to obtain additional financing. Up to this point, GESS' primary source of funds has been from the sale of common stock. The company is entirely equity-financed except for current liabilities incurred in the course of day to day operations. There are 200,000 shares outstanding, which are mostly owned by large, diverse, technology companies that may wish to partner with or even acquire GESS at some point in the future. The shares trade occasionally in the NASDAQ over the counter (OTC) market at an average price of $20. The investment bankers who placed the stock have suggested that an all debt plan would minimize the taxes paid to Government, but it would be risky and leave little room for foe future borrowing. Instead, they recommend staying close to the industry average for debt-to-asset and debt-to-equity ratios. They have proposed two alternative plans. $2,000,000 of new equity (100,000 new shares at the firm's current stock price of approximately $20) and 4000,000 of privately placed debt at 9% $4,000,000 of new equity (200,000 new shares at the firm's current stock price of approximately $20) and 2000,000 of privately placed debt at 8% Under plan, GESS' combined state and federal marginal tax rate will be 40% Why should GESS expect to pay a higher rate of interest if it borrows $4,000,000 rather than $2,000,000? Estimate earnings per share for Plan A and Plan B at EBIT levels of $800,000, $1,000,000, and $1,200,000. How do taxes affect your findings in Question 2?By how much would the value of GESS increase or decrease as a result of choosing Plan A or Plan B? At what level of EBIT would EPS be the same under either plan? Suppose GESS's management is fairly confident that EBIT will be at least $1,000,000. Which plan would the firm be most likely to choose? Assume that GESS has no internal sources of financing and does not pay dividends. Under these conditions, would the pecking order hypothesis influence the decision to use Plan A or Plan B? We assume that the decision to use more or less debt did not change the price of the stock. Under real-life conditions, how would the decision be likely to affect the stock price at first, and later, if management's optimism turned out to be justified? What if 40% of GESS's stock was owned by a large pharmaceutical company and this company also purchased 40% of the privately placed debt? Would this situation influence the decision to use Plan A or Plan B?