Question 2 (23 Marks)

a) (7 marks) ACE Company has no debt and 1 Million shares @ $10/sh and is considering a $4 Million expansion by issuing perpetual debt with an 8% interest rate. Calculate the EPS for the expanded firm at EBIT of $500K p.a. and then compare it to the EPS of an all equity financed expansion (assuming new equity is issued @ $10/sh.) Use a graph of EPS vs. EBIT to illustrate your answer, calculate the intercepts and indifference point.

b) (4 marks) If taxes are 40%, calculate their effect on (a).

c) (4 marks) Calculate the Financial Leverage (F.L.) at EBIT of $1.12 M for the levered expansion alternative in (a) (no taxes). Explain and check your answer by calculating EPS at 2.12 M EBIT using the elasticity definition of F.L.

d) (4 marks) Repeat (c) for EBIT of $500K and explain the differences to your answer in (c). e) (4 marks) Calculate the probability the levered alternative has a higher E.P.S. if EBIT is normally distributed with mean $1 Million and standard deviation of $0.2 Million.