Problem #1(19 marks)

Serenas Soaps is planning a major expansion program requiring $5,000,000 in financing. Serenas may

sell bonds with an 8% coupon rate or sell 200,000 shares of common stock to get the needed funds.

After the expansion there is a 30% probability of EBIT (Earnings Before Interest and Taxes) being $2

million, a 50% probability of it being $3 million and a 20% probability of it being $4 million. The

following data was taken from the firms pre-expansion income statement:

Interest expense $100,000

Tax Rate 40%

Common shares outstanding 300,000

a) Calculate the EPS based on the expected EBIT under each alternative. (5 marks)

b) Which plan would you chose at this level of EBIT? (1 mark)

c) Compute the DFL (Degree of Financial Leverage) under each financing alternative. If EBIT

increased by 10%, what would the new EPS be under each alternative? (6 marks)

d) What level of EBIT would yield the same EPS for the stock and debt alternatives? (5 marks)

e) What EPS corresponds to this level of EBIT? (2 marks)