Roberts, Inc. is trying to decide how best to finance a proposed $10 million capital investment. Under Plan I, the project will be financed entirely with long-term 9% bonds
The firm currently has no debt or preferred stock. Under Plan II, common stock will be sold to net the firm $20 a share; presently, 1 million shares are outstanding. The corporate tax rate for Roberts is 40%.
a. Calculate the indifference level of EBIT associated with the two financing plans.
b. Which financing plan would you expect to cause the greatest change in EPS relative to a change in EBIT? Why?
c. If EBIT is expected to be $3.1 million, which plan will result in a higher EPS?
Answer:
a. (EBIT)(1 - 0.4)/1,500,000 =
(EBIT - $900,000)(1 - 0.4)/1,000,000
EBIT = $2,700,000
b. The bond plan will magnify changes in EPS since adding debt increases financial leverage.
c. Since $3.1 million EBIT is above the indifference point of $2.7 million, the bond plan will give a higher EPS.
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