The Anaya Corporation is a leader in artificial intelligence research. Anaya’s present capital structure consists of common stock (30 million shares) and debt ($250 million with an interest rate of 15 percent). The company is planning an expansion and wishes to examine alternative financing plans. The firm’s marginal tax rate is 40 percent.
Two alternatives under consideration are:
Plan 1: Common equity financing. An additional 3 million shares of common stock will be sold at $20 each.
Plan 2: Debt financing. The firm would sell $30 million of first-mortgage bonds with a pretax cost of 14 percent and $30 million of debentures with a pretax cost of 15 percent.
a. Compute the indifference point between these two alternatives.
b. One of Anaya’s artificially intelligent financial managers has suggested that the firm might be better off to finance with preferred stock rather than common stock. He suggested that the indifference point be computed between the debt financing alternative and a preferred stock financing alternative. Preferred stock ($60 million) will cost 16 percent after tax. Which option should be selected on an EPS basis? (No calculations are necessary if you set the problem up and think about the implications.)