NoNuns Cos. has a 25 percent tax rate and has $302.40 million in assets, current

Question

NoNuns Cos. has a 25 percent tax rate and has $302.40 million in assets, currently financed entirely with equity. Equity is worth $30 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 25-percent-debt capital structure, and has determined that it would have to pay an 10 percent yield on perpetual debt in either event. What will be the standard deviation in EPS if NoNuns switches to the proposed capital structure? (Do not round intermediate calculations and round your final answer to 2 decimal places.)

State Recession Average Boom Probability of state 0.20 0.55 0.25 Expected EBIT in state $ 5,846,400 $ 11,995,200 $ 18,950,400

Explanation / Answer

First we calculate the EPS with all equity assets

Number of shares = 302,400,000/30 = 10,080,000 shares

The EPS is calculated as shown in the table below:

Mow we calculate the EPS with the debt issue

25% of debt means = 0.25*302,400,000 = 75,600,000

Number of shares to be repurchased = 75,600,000/30 = 2,520,000 shares

Number of shares outstanding = 10,080,000 - 2,520,000 = 7,560,000 shares

Interest on debt = 75,600,000*0.10 = 7,560,000

The EPS after debt issue is calculated as follows:

Now we calculate the std. deviation in EPS using stdev()

Standard deviation in EPS = 31.10% (Rounded to 2 decimals)

State Recession Average Boom Probability 0.2 0.55 0.25 EBIT 5846400 11995200 18950400 Taxes at 25% -1461600 -2998800 -4737600 Net Income 4384800 8996400 14212800 Number of shares 10080000 10080000 10080000 EPS 0.435 0.8925 1.41 EPS (Weigted average) $                        0.930375

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