Percy’s, Inc. is considering the purchase of a small company which supplies the firm with a major component used to manufacture its main product. The purchase would be financed by the sale of common stock or a bond issue. The financial manager needs to evaluate how the two alternative financing plans would affect the earnings potential of the firm. Total financing required is $3.0 million. The firm currently has $7,000,000 of 10% bonds and 200,000 shares of common stock outstanding. The firm can arrange financing of the $3.0 million through either a 12% bond issue or the sale of 50,000 shares of common stock. The firm’s tax rate is 40%.
(a) At what EBIT level will EPS $0 for each financing plan?
(b) Graph the two financing plans on a set of EBIT EPS axes. (Calculate and plot EPS at EBIT levels of $250,000, $500,000, $1,000,000, $1,500,000, $2,500,000, and $3,500,000.)
(c) According to your graph, at what EBIT level does the bond financing plan become superior?
(d) If the firm estimates EBIT of $3,000,000, which financing plan would you recommend?
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