HiLo, Inc., doesn’t face any taxes and has $128.5 million in assets, currently f
ID: 2786189 • Letter: H
Question
HiLo, Inc., doesn’t face any taxes and has $128.5 million in assets, currently financed entirely with equity. Equity is worth $6 per share, and book value of equity is equal to market value of equity. Also, let’s assume that the firm’s expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities as shown below:
The firm is considering switching to a 40-percent-debt capital structure, and has determined that it would have to pay a 9 percent yield on perpetual debt in either event. What will be the level of expected EPS if the firm switches to the proposed capital structure? (Do not round intermediate calculations and round your final answer to 2 decimal places.)
HiLo, Inc., doesn’t face any taxes and has $128.5 million in assets, currently financed entirely with equity. Equity is worth $6 per share, and book value of equity is equal to market value of equity. Also, let’s assume that the firm’s expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities as shown below:
Explanation / Answer
Total Equity Value = No. of shares x Stock Price
Here, Equity Value = Asset Value = 128,500,000
=> No. of shares = 128,500,000 / 6 = 21,416,667 shares
Expected EBIT = 40% x 2,313,000 + 60% x 16,576,500 = 10,871,100
Debt = 40% x 128,500,000 = 51,400,000
Interest expense = 51,400,000 x 9% = 4,626,000
No. of shares repurchased = Debt / Share Price = 51,400,000 / 6 = 8,566,667
After the repurchase, shares outstanding = 21,416,667 - 8,566,667 = 12,850,000
Net Income = (EBIT - Interest) x (1 - tax rate)
As the tax rate isn't mentioned, I assume it to be 0.
=> Net Income = 10,871,100 - 4,626,000 = 6,245,100
=> EPS = Net Income / No. of shares = 6,245,100 / 12,850,000 = $ 0.49
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