A firm that wants to raise $15 million has 800,000 common shares outstanding with a

current market value of $25, and has $10,000,000 bonds with a 5% annual coupon

payment. The firms tax rate is 40 percent.

(a)

The alternatives are to issue common shares or to issue 15-year bonds, at face

value, with annual coupon payments of 8 percent. Issuing and underwriting costs

can be ignored.

Compute the indifference EBIT between common shares and

bonds. If expected EBIT is greater than the indifference EBIT which

financing option should be pursued?

(b)

The $15 million could also be raised by issuing preferred shares at $100 per share

with an annual dividend rate of 10 percent. Issuing and underwriting costs can be

ignored.

Compute the indifference EBIT between common shares and

preferred shares. If expected EBIT is less than the indifference EBIT which

financing option should be pursued?

(c)

Is a decision strictly based on maximizing EPS appropriate? What additional

factor(s) must be considered before a decision is made? Discuss