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

market value of $15 per share. The firm's tax rate is 40 percent.

(a)

The alternatives are to issue common shares or to issue 20-year debentures (bonds) at face value with annual interest payments of 12 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 $21 million 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.