Office Systems Supplies (OSS) has set out on a major expansion of its manufacturing facilities will require $4 million in external financing and is expected to increase earnings before interest and taxes(EBIT) by $8,00,000 on average. Three financing alternatives are being evaluated: long term debt, preferred stock and common stock. Debt can be issued to finance the entire $ 4 million needed at an interest rate of 8 percent. A $4 million preferred stock issue would require a dividend of 9 percent whereas a $4 million common stock issue would require the firm to issue 200,000 new shares.

OSS currently has 600,000 shares of common stock outstanding, no preferred stock and debt carrying an annual interest cost of 280,000. The Income tax rate for OSS is 30 percent. Management considers that EBIT with the new facilities in place is highly unlikely to be less than $ 4, 00,000 in any year. The expected level of EBIT is $3.0 million per year.

1. Develop an EBIT-EPS graph showing the three financing alternatives under assumptions that tax credits will be available in the event of losses and that preferred dividends will be paid even if not earned.
2. Compare the three alternatives and indicate which one, in your judgment, seems most appropriate.
3. Are there any other alternatives that you believe should be considered based on your evaluation in it?
4. Suppose that preferred dividends are paid only to the extent they are earned. How would this affect your analysis/evaluation?