Suppose that Company X has decided in favor of a capital restructuring that invo

Question

Suppose that Company X has decided in favor of a capital restructuring that involves
increasing debt and repurchasing equity. The debt will increase from €5 million to €25
million. The interest rate on the debt is 12% and it is not expected to change. The firm
currently has 1 million shares outstanding, and the price per share is €40. If the
restructuring is expected to maintain earnings per share (EPS), what is the level for
earnings before interest and taxes (EBIT) that the management must be expecting? Ignore taxes and costs of financial distress.

Explanation / Answer

Increase in Debt = $25M-$5M = $20M Increase in Int on Debt = 12%*$25M = $3M So assuming, Debt increase is prop to reduction in Equity, No of shares purchased = 20M/40 = 0.5M. SO new Equity is 0.5M EPS = EBIT1/No of shares outstanding Before Inc in Debt, EPS1 = EBIT1/1M Post Debt, EBIT2 & New Equity is 0.5M. So EPS2 = EBIT2/0.5M As EPS1 = EPS2 for maintaining same level of EPS before & after debt issue, we get EBIT1/1M = EBIT2/0.5M ie EBIT1 = 2EBIT2 Thus Management will be expecting EBIT post debt to be double that of before debt EBIT

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