Financing Example - EPS Impact of Alternatives

At the beginning of year 1, the firm needs to raise $10M of capital to expand.

Assume the following data:

• Projected year 1 Income, post-financing = $4M
• Shares outstanding, pre financing = 4M
• The company pays no dividends, the interest rate is 5%

and volatility is 35%

• Annual Rate of earnings growth - after year 1 =20%

(Note this is not necessarily the rate of

EPS growth)

• Assumed PE multiple on earnings for equity valuation = 20X next years earnings.
• Tax rate =40%

There are three financing approaches

• Sell $10M of straight equity
• Sell $10M of 5-year at-the-money warrants
• Sell $10M of straight bonds. The bonds have an interest rate of 8%.

Required:

For each of the first 5 years, compute projected EPS under each financing approach.

Each year, you will need to compute the following:

1. Enterprise value (based on earnings growth)
2. The stock plus warrant value (using Black-Scholes).
3. Note that the stock, debt, and warrant values combined must equal enterprise value.
4. When the options are first issued, they must have a value of $10M.