Two inventive entrepreneurs have interested a group of venture capitalists in backing a new business project. The proposed plan would consist of series of international retail outlets to distribute and service a full line of ingenious home garden tools. The stores would be located in high-traffic cities in Latin America such as Panama City, Bogota, Sao Paulo, and Buenos Aires. Two financing plans have been proposed by the entrepreneurs. Plan A is an all common-equity structure. Five million dollars would be raised by selling 160,000 shares of common stock. Plan B would involve the use of long-term debt financing. Three million dollars would be raised by marketing bonds with an effective interest rate of 14 percent. Under the alternative, another $2 million would be raised by selling 64,000 shares of common stock. With both plans, $5 million is needed to launch the new firm’s operations. The debt funds raised under plan B are considered to have no fixed maturity date, because this portion of financial leverage is thought to be a permanent part of the company’s capital structure. The two promising entrepreneurs have decided to use a 35 percent tax rate in their analysis, and they have hired you on a consulting basis to do the following:
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Find the EBIT indifference level associated with the two financing proposals.
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Prepare income statements for the two plans that prove EPS will be the same regardless of the plan chosen at the EBIT level in part (a).
