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A movie theater is under construction. It will have 800-seat capacity and management plans to have 800 showings per year. The ticket price will average $1.25 per person, and the total annual operating expenses are almost certain to be $300,000. Management feels that there is a 20% chance the theater will operate at full capacity, a 60% chance the theater will operate at 80% capacity and a 20% chance the theater will operate at 60% capacity. The cost of the new theater will be $900,000 of which $100,000 is available from internal funds. Two financing alternatives for the remaining $800,000 are being considered: using all common stock or by issuing bonds at 10%. Assume common stock can be sold for $100/share, current shareholders own 10,000 shares and the tax rate is 40%
a) Develop an EBIT-EPS relationship for the financing alternatives.
b) At what level of EBIT will management be indifferent between the two alternatives?
c) What financing alternatives should management adopt? Why?
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