Problem
A firm that wants to raise $21 million has 500,000 common shares outstanding, with a current market value of $16 per share. The firm's tax rate is 40 percent.
i. The alternatives are to issue common shares that would net the company $15 per share or to place 20-year debentures (bonds) at face value with annual interest payments of 12 percent. Issuing and underwriting expenses can be ignored. Compute the indifference EBIT. If expected EBIT is greater than the indifference EBIT which financing option should be pursued?
ii. The $21 million could also be raised by issuing 525,000 preferred shares to net the company $40 per preferred share at an annual dividend rate of 10 percent. Compute the indifference EBIT between common shares and preferred shares. If expected EBIT is less than the indifference EBIT which financing option should be pursued?
iii. Is a decision based on maximizing EPs appropriate? What additional factor(s) must be considered before a decision is taken? Discuss.