Greta’s Greenhouses Inc. is planning a major expansion program requiring $5,000,000 in financing. Greta’s may sell bonds with an 8% coupon rate (option #1) or sell 200,000 shares of common stock (option #2) to get the needed funds. After the expansion there is a 30% probability of EBIT (Earnings Before Interest and Taxes) being $2 million, a 50% probability of it being $3 million and a 20% probability of it being $4 million. The following data was taken from the firm’s pre-expansion income statement:
Interest expense $100,000
Tax Rate 40%
Common shares outstanding 300,000
a) Calculate the EPS based on the expected EBIT under each alternative.
b) Which plan would you chose at this level of EBIT?
c) Which option will have the higher DFL (Degree of Financial Leverage – no calculation required)?
d) What level of EBIT would yield the same EPS for the stock and debt alternatives?
e) What EPS corresponds to this level of EBIT?
f) Instead of Option #2 (issuing 200,000 common shares), if the company decided they should issue only 100,000 common shares at $25 each and finance the remainder of the project with 3% preferred shares, what would the indifference point be?