Assume that Rose Corporation’s (RC) EBIT is not expected to grow in the future a

Question

Assume that Rose Corporation’s (RC) EBIT is not expected to grow in the future and that all earnings are paid out as dividends. RC is currently an all-equity firm. It expects to generate earnings before interest and taxes (EBIT) of $6 million over the next year. Currently, RC has 5 million shares outstanding and its stock is trading for a price of $12 per share. RC is considering borrowing $12 million at a rate of 6% and using the proceeds to repurchase shares at the current price of $12.

Following the borrowing of $12 and subsequent share repurchase, the expected earnings per share for RC is closest to:

(1) $1.32
(2) $1.44
(3) $1.40
(4) $1.20

Explanation / Answer

Ans: 1.32 (this is assuming there are no taxes) EBIT = 6,000,000 Less Interest on borrowing @6% 720,000 Earning before Taxes 5,280,000 After the repurchase RC would have 4 million shares outstanding, hence the new EPS (before taxes) should be 5,280,000/4,000,000 = 1.32

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