1. Chin Hee and three of his friends from college have interested a group of venture capitalists in backing their business idea. The proposed operation would consist of a series of retail outlets to distribute and service a full line of vacuum cleaners and accessories. These stores would be located in Kuantan, Ipoh, Kota Bharu and Johor. To finance the new venture two plans have been proposed:

• Plan A is an all-common-equity structure in which RM2,000,000 would be raised by selling 80,000 shares of common stock.
• Plan B would involve issuing RM1,000,000 in long-term bonds with an effective interest rate of 12 percent plus another RM1,000,000 would be raised by selling 40,000 shares of common stock. The debt fund raised under Plan B has no fix maturity date, in that this amount of financial leverage is considered a permanent part of the firms capital structure.

Chin Hee and his partners plan to use a 40 percent tax rate in their analysis, and they have hired you to do the following:

Required:

1. Find the break-even EBIT (earnings before interests and taxes) associated with the two financing plans. (5 marks)

(CLO3:PLO7:C3)

2. If the EBIT is expected to be RM400,000, which financing plan should be selected and why? (4 marks) (CLO3:PLO7:C3)

2. Cloudy Corporation has no debt outstanding and a total market value of RM175,000. EBIT are projected to be RM16,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 35 percent higher. Cloudy is considering a RM70,000 debt issue with a 7 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 2,500 shares outstanding. Cloudy has a tax rate of 34 percent.

Required:

Calculate the earnings per share (EPS) under each of these economic scenarios assuming that the company goes through with recapitalization.

(8 marks)

(CLO3:PLO7:C3)