Fresh out of Harvard Business School, Joe Walker, the new CFO of Joe\'s Southern

Question

Fresh out of Harvard Business School, Joe Walker, the new CFO of Joe's Southern Cornbread Company, wants to shake things up at the sleepy little food company headquartered in Birmingham, Alabama. The firm is currently an all-equity firm because "that's the way we've always done it." Under pressure from a new group of major stockholders, however, Walker is considering acquiring some debt (leverage) in an effort to boost earnings per share. The company currently has 600 shares, but he is thinking about borrowing $6,000 at 10% per year and buying back 200 of those shares.

Refer to the scenario above. What level of EBIT would make this an attractive strategy?   

2) When estimating a weighted average cost of capital, a firm can use either book values or market values for estimating the value of the component sources of capital. Where would you find book values, and what value do they represent? How would you calculate market values? In general, would you prefer to use market or book values for estimating the WACC? Under what circumstances would you use book values?

Explanation / Answer

Let EBIT = X

After taking on debt profit after interest = X - 600

Previous EPS = X / 600

New EPS = (X - 600) / 400

New EPS must be > old EPS for it to be an attractive strategy

600(X-600) = 400X

200X = 600*600

X = 1800

EBIT level = $1,800 for attractive strategy

The book value is literally the value according to the businesses own

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