Question

Consider a firm with an EBITDA of $1,100,000 and an EBIT of $1,000,000. The firm finances its assets with $4,600,000 debt (costing 8.6 percent) and 206,000 shares of stock selling at $13 per share. To reduce risk associated with this financial leverage, the firm is considering reducing its debt by $2,600,000 by selling additional shares of stock. The firm’s tax rate is 21 percent. The change in capital structure will have no effect on the operations of the firm. Thus, EBIT will remain at $1,000,000. Calculate the EPS before and after the change in capital structure and indicate changes in EPS.

Answer 1

The EPS before the change in capital structure is $3.54, and the EPS after the change is $2.47.

Step-by-step explanation:

The formula to calculate earnings per share (EPS) is:

EPS = (EBIT - Interest Expense) * (1 - Tax Rate) / Number of Shares

Before the change in capital structure, the interest expense is the cost of debt, which is 8.6 percent of $4,600,000, resulting in $395,600. So, the EPS before the change is: ($1,000,000 - $395,600) * (1 - 0.21) / 206,000 = $3.54

After the change, the interest expense will be reduced by $2,600,000, so it will be $395,600 - ($2,600,000 * 0.086) = $155,600. The number of shares will increase to 206,000 + ($2,600,000 / $13) = 400,000. Therefore, the EPS after the change is: ($1,000,000 - $155,600) * (1 - 0.21) / 400,000 = $2.47