Assume that Rose Corporation’s (RC) EBIT is not expected to grow in the future a
ID: 2711112 • Letter: 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.
A) Prior to any borrowing and share repurchase, RC’s EPS (i.e., earnings per share) is closest to:
1. $0.60
2. $1.00
3. $1.20
4. $0.50
B) Prior to any borrowing and share repurchase, the equity cost of capital for RC is closest to:
1. 8%
2. 10%
3. 12%
4. 9%
C) Following the borrowing of $12million and subsequent share repurchase, the number of shares that RC will have outstanding is closest to:
1. 4.0 million
2. 6.0 million
3. 4.9 million
4. 4.5 million
D) Following the borrowing of $12 and subsequent share repurchase, the equity cost of capital for RC is closest to
1. 12%
2. 9%
3. 11%
4. 10%
E) 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
F) Following the borrowing of $12million and subsequent share repurchase, the value of a share of RC is closest to:
1. $14.00
2. $13.20
3. $12.00
4. $10.80
Explanation / Answer
A)
EPS = EBIT / Outstanding shares
= $6,000,000 / $5,000,000
= $1.20
Option 3 is the correct answer.
B)
Current stock price = EPS / rU
rU = $12.00 / $1.20 = 0.10
Option 2 is the correct answer.
C)
Repurchased shares = $12,000,000 / $12 per share = 1,000,000 shares
Total outstanding shares = 5,000,000 shares – 1,000,000 Repurchased shares
= 4,000,000 shares
Option 1 is the correct answer.
D)
5,000,000 shares*$12 per share = $60,000,000
rE = rU + D/E* (rU – rD)
= 0.10 + 12/ (60,000,000 – 12,000,000)* (0.10 – 0.06)
= 0.11 or 11%
Option 3 is the correct answer.
E)
EBIT
6000000
Less: interest on borrowing @ 6% (12,000,000*0.06)
720000
EBT
5280000
Expected EPS = EBT / Total outstanding shares
= 5,280,000 / 4,000,000
= $1.32
Option 1 is the correct answer.
F)
Value of share = Expected EPS / rE
= $1.32 / 0.11
= $12.00
Option 3 is the correct answer.
EBIT
6000000
Less: interest on borrowing @ 6% (12,000,000*0.06)
720000
EBT
5280000
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