Rene's Renovations Inc. is planning a major expansion program requiring $5,000,000 in financing.
Option #1: Rene's may sell bonds with an 8% coupon rate, or
Option #2: Rene's may sell 200,000 shares of common stock 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 EBIT being $3 million and a 20% probability of EBIT 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. (5 marks)
- b) Which plan would you chose at this level of EBIT? (1 mark)
- c) Which option will have the higher DFL (Degree of Financial Leverage - no calculation required)? (1
- d) What level of EBIT would yield the same EPS for the stock and debt alternatives? (5 marks)
- e) What EPS corresponds to this level of EBIT? (2 marks)
- 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? (5 marks)
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