Consider a firm with an EBIT of $550,000. The firm finances its assets with $1,0

Question

Consider a firm with an EBIT of $550,000. The firm finances its assets with $1,000,000 debt (costing 5.5 percent) and 200,000 shares of stock selling at $12.00 per share. The firm is considering increasing its debt by $900,000, using the proceeds to buy back 75,000 shares of stock. The firm is in the 40 percent tax bracket. The change in capital structure will have no effect on the operations of the firm. Thus, EBIT will remain at $550,000. Calculate the EPS before and after the change in capital structure and indicate changes in EPS. (Round your answers to 4 decimal places.)

Explanation / Answer

EBIT = $550000

Less- interest = 55000

EAT = 495000

Less- tax@40% = 198000

Earnings available for equity shareholders = 297000

EPS = EARNINGS AVAILABLE FOR EQUITY SHAREHOLDERS/ NUMBER OF SHARES OUTSTANDING

= 297000 / 200000

= 1.485

After increasing debt by $900000, total debt = 1900000

Interest on debt = 104500

Share outstanding after buy back = 200000-75000 = 125000

EBIT = $550000

Less- interest = 104500

EAT = 445500

Less- tax@40% = 178200

Earnings available for equity shareholders = 267300

EPS = EARNINGS AVAILABLE FOR EQUITY SHAREHOLDERS/ NUMBER OF SHARES OUTSTANDING

= 267300 / 200000

= 1.3365

EPS before

1.485

EPS after

1.336

Difference

0.15

EPS before

1.485

EPS after

1.336

Difference

0.15

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