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Due to a boom in tourists to Australia, there is increasing interest in Australian animal memorabilia. You wish to evaluate the possibility of an expansion
Due to a boom in tourists to Australia, there is increasing interest in Australian animal memorabilia. You wish to evaluate the possibility of an expansion of your current business to include this segment. All that is lacking for the next phase of the company's development is adequate financing. A small group of boutique private investors are interested in providing finance with two differing structures. The first structure, plan A, is an all-ordinary-share capital structure. $5 million would be raised by selling 1 million shares at $5 each. The second structure, plan B, would involve the use of financial leverage. $1 million would be raised by issuing bonds with an effective interest rate of 7% (per annum). Under this plan, the remaining $4 million would be raised by selling 800,000 shares at $5 price per share. The use of financial leverage is considered to be a permanent part of the firm's capitalisation, so no fixed maturity date is needed for the analysis. A 25% tax rate is appropriate 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. (7 marks) (b) A detailed financial analysis of the firm's prospects suggests that the long-term EBIT will be $300,000 annually. Taking this into consideration, which plan will generate the higher EPS? (2 marks) (c) Briefly explain the primary weakness of EBIT-EPS analysis as a financing decision tool. (4 marks)
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