HiLo, Inc., doesn’t face any taxes and has $319.75 million in assets, currently

Question

HiLo, Inc., doesn’t face any taxes and has $319.75 million in assets, currently financed entirely with equity. Equity is worth $20 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:

State                                   Pessimistic        Optimistic

Probability of state 0.45                    0.55

Expected EBIT in state     $ 1,534,800    $ 16,754,900

The firm is considering switching to a 20-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.)

Expected EPS $__________

Explanation / Answer

20% Debt means 319.75*20%=63.95 million Debt

So, Interest on Debt=9%*63.95=5.7555 million

Equity=80%*319.75=255.8 million

Number of shares=255.8/20=1.279 million

Net income in pessimisitc=1534800-5755500=-4220700

Hence, EPS=0 as the income is not sufficient to meet debt obligations

Net income in optimistic=16754900-5755500=10999400=1.09994 million

So, EPS=1.09994/1.279=0.86

Expected EPS=0*0.45+0.86*0.55=$0.473

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