Find The EBIT Indifference Level Associated With The Two Fin

Abe Forrester and three of his friends from college have interested a group of venture capitalists in backing their business idea. The proposed operation would consist of a series of retail outlets to distribute and service a full line of vacuum cleaners and accessories. These stores would be located in Dallas, Houston, and San Antonio. To finance the new venture, two plans have been proposed. Plan A is an all-common-equity structure in which $2.3 million would be raised by selling 84,000 shares of common stock. Plan B would involve issuing $1.1 million in long-term bonds with an effective interest rate of 11.7%, plus $1.2 million raised by selling 42,000 shares of common stock. The debt funds raised under Plan B have no fixed maturity date and are considered a permanent part of the firm's capital structure. Abe and his partners plan to use a 40% tax rate in their analysis, and they have hired you on a consulting basis to do the following:

A. Find the EBIT indifference level associated with the two financing plans.

B. Prepare a pro forma income statement for the EBIT level found in Part a that shows EPS will be the same regardless of whether Plan A or Plan B is chosen.

Find the EBIT indifference level associated with the two financing plans

The goal of this analysis is to determine the level of EBIT at which the earnings per share (EPS) remain the same for both financing plans. This EBIT indifference point provides valuable insight into the firm's optimal capital structure by identifying the level of operating income where the choice of financing does not affect shareholder earnings.

Step 1: Understanding the details of each plan

Plan A involves raising $2.3 million through issuing 84,000 shares of common stock. The cost of equity is implicit, and since there is no debt involved, the firm’s total capital is equity-financed. The earnings per share in this scenario depend solely on the net income attributable to common shareholders divided by the number of shares (84,000).

Plan B, on the other hand, involves a mix of debt and equity financing. The firm raises $1.1 million through bonds with an 11.7% effective interest rate and $1.2 million by issuing 42,000 shares of common stock. The interest expense on the bonds introduces financial leverage into the structure, impacting the firm's net income and EPS.

Step 2: Calculate the interest expense under Plan B

The interest expense (I) is calculated as:

I = Debt × Interest Rate = $1,100,000 × 11.7% = $128,700

Step 3: Derive the EBIT-earnings relationships for each plan

For Plan A, earnings before interest and taxes (EBIT) directly translate into net income, adjusted for taxes, since there's no debt:

Net Income = (EBIT - Taxes) = EBIT × (1 - Tax Rate) = EBIT × (1 - 0.40) = EBIT × 0.60

EPS (Plan A) = Net Income / Number of Shares = (EBIT × 0.60) / 84,000

For Plan B, EBIT is after interest expense is deducted:

Net Income = (EBIT - Interest Expense) × (1 - Tax Rate)

Net Income (Plan B) = (EBIT - $128,700) × 0.60

EPS (Plan B) = Net Income / Number of Shares = [(EBIT - 128,700) × 0.60] / 42,000

Step 4: Set EPS equal to find the indifference EBIT level

To find the EBIT level where EPS are equal under both plans:

[(EBIT × 0.60) / 84,000] = {[(EBIT - 128,700) × 0.60] / 42,000}

Step 5: Solve for EBIT

Cross-multiplied:

(EBIT × 0.60) × 42,000 = (EBIT - 128,700) × 0.60 × 84,000

This simplifies to:

EBIT × 0.60 × 42,000 = (EBIT - 128,700) × 0.60 × 84,000

Divide both sides by 0.60:

EBIT × 42,000 = (EBIT - 128,700) × 84,000

Expand the right side:

EBIT × 42,000 = 84,000 × EBIT - 84,000 × 128,700

Bring all EBIT terms to one side:

EBIT × 42,000 - 84,000 × EBIT = - 84,000 × 128,700

Factor EBIT out:

EBIT (42,000 - 84,000) = -84,000 × 128,700

EBIT ( - 42,000) = -84,000 × 128,700

Divide both sides by -42,000:

EBIT = (84,000 × 128,700) / 42,000

Calculate the numerator:

84,000 × 128,700 = 10,810,800,000

Divide by 42,000:

EBIT = 10,810,800,000 / 42,000 ≈ 257,400

Final Answer: The EBIT indifference level is approximately $257,400

Paper For Above instruction

The determination of the EBIT indifference point between different capital structures is essential for corporate financial decision-making. This analysis ensures that managers and investors understand at which level of operating income the choice of financing—debt or equity—does not impact earnings per share (EPS). In this context, evaluating the points of indifference informs optimal capital structure decisions that align with the company's financial strategy and market conditions.

In the scenario provided, two distinct financial plans are considered for funding a new retail business specializing in vacuum cleaners and accessories across three major Texas cities: Dallas, Houston, and San Antonio. The first plan utilizes all equity financing, while the second employs a balanced approach with debt and equity, introducing financial leverage. Calculating the EBIT indifference point involves equating the EPS under both plans, considering taxes and interest expenses, thus enabling a comparison of the economic viability of each structure at different levels of operating income.

For Plan A, the simplest scenario involves entirely equity-financed capital. EBIT directly influences net income, which after accounting for taxes, determines the EPS. Since there is no interest expense, the relation between EBIT and EPS is straightforward: EPS increases linearly with EBIT, scaled by the number of shares and after tax profit margins. Plan B, incorporating debt, modifies this relationship because interest payments reduce net income but can also provide tax shields due to deductible interest expenses. This introduces financial leverage, magnifying the effects of EBIT variations on net income and EPS.

The critical step in identifying the indifference EBIT involves setting the EPS calculations equal for both plans and solving for EBIT. By doing this, the point is found at approximately $257,400, indicating that when EBIT is below this level, one financing plan might yield higher EPS; above this level, the other plan becomes more advantageous. Knowing this threshold guides the company's management in choosing appropriate financing structures aligned with anticipated operational performance.

Understanding the implications of the indifference point extends beyond simple calculations. It highlights the risks associated with leverage, where below the EBIT threshold, the debt-burdened structure might lead to disproportionate income fluctuations, whereas above it, the leverage enhances earnings. Consequently, the firm's strategic planning must account for realistic EBIT forecasts and market volatility, ensuring that the chosen capital structure optimally supports growth and stability.

Prepare a pro forma income statement for the EBIT level found in Part a that shows that EPS will be the same regardless whether Plan A or Plan B is chosen

At EBIT of \$257,400, we construct the pro forma income statements for both plans to verify that EPS are equal.

Plan A Income Statement

• EBIT: \$257,400
• Interest Expenses: \$0
• Taxable Income: \$257,400
• Taxes (40%): \$102,960
• Net Income: \$154,440
• Shares Outstanding: 84,000
• EPS: \$154,440 / 84,000 ≈ \$1.84

Plan B Income Statement

• EBIT: \$257,400
• Interest Expenses: \$128,700
• Taxable Income: \$128,700
• Taxes (40%): \$51,480
• Net Income: \$77,220
• Shares Outstanding: 42,000
• EPS: \$77,220 / 42,000 ≈ \$1.84

Both plans yield approximately the same EPS at this EBIT level, confirming the indifference point established earlier. This example underscores the importance of considering both operational performance and capital structure when making financing decisions. It also demonstrates how leverage impacts profitability and shareholder earnings at different levels of earnings before interest and taxes. Proper strategic planning requires a thorough understanding of these dynamics to optimize value creation for shareholders.

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