Consider a firm with an EBIT of $10,500,000. The firm finances its assets with $

Question

Consider a firm with an EBIT of $10,500,000. The firm finances its assets with $50,000,000 debt (costing 6.5 percent) and 10,000,000 shares of stock selling at $10.00 per share. The firm is considering increasing its debt by $25,000,000, using the proceeds to buy back 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 $10,500,000. Calculate the change in the firm’s EPS from this change in capital structure.

Explanation / Answer

Old capital structre New capital structure EBIT 10500000 10500000 Less: interest 3250000 4875000 50000000*6.5% 75000000*6.5% Earnings before taxes 7250000 5625000 Less: Taxes 2900000 2250000 Earnings after taxes 4350000 3375000 Number of shares 10000000 7500000 (10000000-2500000) Earnings per share 0.435 0.45 (4350000÷10000000) (3375000÷7500000) Earnings per share increased to 0.45. Therefore, firm value has increased

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