16-5B. (ERIT-EPS analysis) Two recent graduates of the computer science program at Ohio Tech are forming a company to write, market, and distribute software for various personal computers.

Initially, the corporation will operate in Missouri, Iowa, Nebraska, and Kansas. Eight prospects for retail outlets in these different states have already been identified and committed to the linn. The firm's software products have been tested. All that is lacking is adequate financing to continue the project. A small group of private investors are interested in financing the new company. Two financing proposals are being evaluated. The first (plan A) is an all-common-equity capital structure.

Three million dollars would be raised by selling stock at $40 per common share. Plan Bwould involve the use of financial leverage. One million dollars would be raised by selling bonds with an effective interest rate of 14 percent (per annum). Under this second plan, the remaining $2 million would be raised by selling common stock at the $40 price per share. This use of financial leverage is considered to be a permanent part of the firm's capitalization, so no fixed maturity date is needed for the analysis. A 50 percent tax rate is appropriate for the analysis.

a. Find the EBIT indifference level associated with the two financing plans.

b. Prepare an analytical income statement that proves EPS will be the same regardless of the plan chosen at the EBIT level found in part

(a) above.

c. A detailed financial analysis of the firm's prospects suggests that long-term EBIT wiU be above $750,000 annually. Taking this into consideration, which plan will generate the higher EPS?

d. Suppose that long-term EBIT is forecast to be $750,000 per year. Under plan A, a price/earnings ratio of 12 would apply. Under plan B, a price/earnings ratio of 9.836 would apply. If this set of financial relationships does hold, which financing plan would you recommend be implemented?