A firm that wants to raise $21 million has 500,000 common shares outstanding, with a current

market value of $1

5

per share. The firm's

tax rate is 40

percent

.

(a)

The alternatives are to issue common shares or to

issue

20

-

year debentures

(bond

s)

at

face value with annual interest payments of 12 percent. Issuing and underwrit

ing

costs

can be

ignored.

Compute the indifference

EBIT

between common shares and bonds

.

If expected EBIT is greater than the indi

fference EBIT

which financing option should be pursued?

(b)

The $21 millio

n could also be raised by issuing 525,000 preferred shares

at $

40 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 based on maximizing EPs appropriate?

What additional factor

(

s

)

must be

considered before a decision is taken? Discuss.