QUESTION B-5 [10 marks]

You are investigating the expansion of your business and have sought out two avenues for the sourcing of funds for the expansion.

The first (Plan A) is an all-ordinary-share capital structure. $10 million would be raised by selling 5,000,000 shares at $2 each.

Plan B would involve the use of financial leverage. $5,000,000 would be raised issuing bonds with an effective interest rate of 12% (per annum). Under this second plan, the remaining $5,000,000 would be raised by selling 2,500,000 shares at $2 price per share. The use of financial leverage is considered to be a permanent part of the firms capitalisation, so no fixed maturity date is needed for the analysis. A 30% tax rate is appropriate for the analysis.

REQUIRED:

1. Find the EBIT indifference level associated with the two financing plans using an EBITEPS graph. Check your results algebraically. (5 marks)
2. A financial analysis of the firms prospects suggests that the long-term earnings before interest and taxes (EBIT) will be $1,000,000 annually. Taking this into consideration, which plan will generate the higher earnings per share (EPS)? (2 marks)
3. Briefly explain the primary weakness of EBIT-EPS analysis as a financing decision tool. (3 marks)