Three recent computer-science graduates are forming a company to write and distribute software for various personal computers. Initially, the company will operate in Eastern Australia. Twelve serious prospects for retail outlets have already been identified and committed to the firm. The firm’s software products have been tested and displayed at several trade shows and computer fairs in the perceived operating region. All that is lacking is adequate financing to continue with the project

. A small group of private investors is interested in financing the company.

Two financing proposals are being evaluated. (A 34% tax rate is appropriate for this analysis.)

1) Plan A is an all-ordinary share capital structure. ‒ $2m dollars would be raised by selling shares at $10 each.

2) Plan B would involve the use of financial leverage. ‒ $1m dollars would be raised selling bonds with an effective interest rate of 11% per annum. ‒ The remaining $1m would be raised by selling shares at the $10 price per share.

The 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.

REQUIRED:

(a) Find the EBIT indifference level associated with the two financing plans using an EBIT-EPS graph. Check your results algebraically.

(b) A detailed financial analysis of the firm’s prospects suggests that long-term EBIT will be above $300,000 annually. Taking this into consideration, which plan will generate the higher EPS?

(c) Suppose long-term EBIT is forecast to be $300,000 per year.

Under plan A, a price/earnings ratio of 19 would apply.

Under plan B, a price/earnings ratio of 15 would apply. If this set of financial relationships does hold, which financing plan would you recommend?