Problem 1 (18 marks):

Fundy Tides Ltd. is considering a large investment of $20,000,000 in a new project. The company currently has $15,000,000 of 5% coupon bonds and 2,000,000 common shares outstanding. The tax rate is 40%. Discussions with an investment banker have assured the firm that the following options are feasible:

o Option 1: Sell $20,000,000 worth of common stock at $50 per share.

o Option 2: Issue $10,000,000 worth of 7% coupon bonds with a 30-year maturity, in addition to $10,000,000 worth of common stock at $50 per share.

a) Calculate the EBIT indifference point for the 2 options. (10 marks)

b) What is the EPS at the EBIT indifference point? At EBIT levels below the EBIT indifference point, which plan would you favour? (3 marks)

c) Fundy would like to consider using preferred stock in Option 2 rather than common stock. Debt would remain unchanged:

o New Option 2: Issue $10,000,000 worth of 7% coupon bonds with a 30-year maturity, in addition to $10,000,000 worth of preferred stock at $50 per share with a dividend of 3% per year.

o Option 1 will remain unchanged (see part (a)).

Calculate the new EBIT indifference point for the 2 options (5 marks)