6.5. São Luís Corporation is an all equity firm with a total value of $22 millio
ID: 2716672 • Letter: 6
Question
6.5. São Luís Corporation is an all equity firm with a total value of $22 million. It requires an additional capital of $7 million, which may be either equity, or debt at the interest rate of 7%. After the new capitalization, the expected EBIT is $6 million, with standard deviation of $2 million. The company pays income tax at 45% rate, and it has 2 million shares outstanding. What is the preferred method of raising new capital, if the objective is to maximize the EPS? What is the probability that you are right in your decision? Show solutions.
Explanation / Answer
Solution :
Suppose the firm raises additional capital of $ 7 million by issuing fresh stock and each stock valued at $ 50
No of fresh stock issued = $ 7,000,000 / $ 50
No of fresh stock issued = 140,000
Total stock outstanding = 2,000,000 + 140,000
stock outstanding = 2,140,000
The interest on debt will be = 0.07 X $ 7,000,000
Interest on debt = $ 490,000
The EBIT has a standard deviation of $ 2 million . Therefore the EBIT can be $ 4 miilion , or $ 6 million or $ 8 million .
If EBIT is $ 6 million or $ 4 million , then the preferred way of raising new capital of $ 7 million is to raise stock .
If EBIT is $ 8 million , then the preferred way of raising new capital of $ 7 million is by debt at and interest rate of 7%
Calculation of Earnings per share under two financing Alternatives Common Stock ( 3 likely possibilities) Debt ( 3 likely possibilities) Earnings before Interest and taxes $6,000,000 $4,000,000 $8,000,000 $6,000,000 $4,000,000 $8,000,000 New Interest on debt _ _ _ $490,000 $490,000 $490,000 Earnings before taxes $6,000,000 $4,000,000 $8,000,000 $5,510,000 $3,510,000 $7,510,000 Earnings after Taxes ( 45%) $3,300,000 $2,200,000 $4,400,000 $3,030,500 $1,930,500 $4,130,500 Number of shares 2,140,000 2,140,000 2,140,000 2,000,000 2,000,000 2,000,000 Earnings Per share $1.54 $1.03 $2.05 $1.51 $0.96 $2.06Related Questions
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