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Problem #2 (22 marks)

The House of Cars Inc. is considering a new investment that will cost $5,000,000 and is expected to increase the companys annual operating earnings (EBIT) by $1,000,000 per year from the current level of $1,750,000 to $2,750,000. The company can raise the $5,000,000 by (1) selling 50,000 shares of common stock at $100 each or, (2) selling bonds with a coupon rate of 8.5% that will net the company $5,000,000. The tax rate is 40%. Below is information on the companys existing capital structure:

Existing Capital Structure	Book Value
Debt Bonds 8% coupon	$6,000,000
Common Stock	11,250,000
Total Liabilities & Owners Equity	$17,250,000
Total common shares outstanding	150,000

1. If EBIT is only $2,000,000, which plan will result in the highest EPS? Show your work. (4 marks)
2. If EBIT is $2,750,000, Which plan will result in the highest EPS? Show your work. (4 marks)
3. Calculate the breakeven EBIT for each plan. (2 marks)
4. At what level of EBIT will the company be indifferent between the 2 plans? (4 marks)
5. Calculate EPS for each plan at this level of EBIT (2 marks)
6. Which plan will have the higher DFL (Degree of Financial Leverage)? No calculation required (1 mark)
7. Instead of Plan #1 (issuing 50,000 common shares), if the company decided they should issue only 25,000 common shares at $100 each and finance the remainder of the project with 4% preferred shares, what would the indifference point be? (5 marks)

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