Question

Firm BUS106 now has 100,000 shares of common stock outstanding, and the total market value of equity equals $5,000,000. It also has an equal amount of debt. Firm BUS106 is expected to generate $1,500,000 in EBIT with a $250,000 of interest expense. Assume tax rate is 0, what will happen to earning per share (EPS) if firm BUS106 buys back $2,500,000 of shares, and the firm substitutes an equal amount of additional debt

Answer 1

EPs befor buy-back 12.5

afer buy-back 22.5

Step-by-step explanation:

current earning per share:

EBIT - interest - taxes = ent income

1,500,000 - 250,000 - 0 = 1,250,000

shares outstanding 100,000

EPS BEFORE BUY-BACK

`EPS = (income-preferred \: dividends)/(outstanding \: common \: stock)`

`EPS = (1,250,000)/(100,000)`

EPS 12.5

After buyback:

the company is buying 2,500,000 /5,000,000 = 50% of the shares

thus it wil drop from 100,000 to 50,000

Now, we solve for the additional interest expense using cross multiplication:

5,000,000 of debt generate 250,000 iunterest

so 2,500,000 will do 250,000 / 5,000,000 x 2,5000,000 = 125,000

Now we solve for net income:

1,500,000 EBIT - 250,000 orignal interest - 125,000 addional= 1,125,000

Last step new EPS

`EPS = (1,125,000)/(50000)`

EPS 22.5

Answer 2

EPS will increase double from $12.5 per share to $25 per share as the buying back takes place.

Step-by-step explanation:

As the firm tax rate is 0, we have the firm's net profit = EBIT - interest expenses = $1,500,000 - $250,000 = $1,250,000.

=> The firm's EPS before the buy back = 1,250,000/100,000 = $12.5

Since the buys back worth $2,500,000 or 50% of the market value of the firm, there is 50% of the shares is bought back which makes only 50,000 shares outstanding. Profit is unchanged this year, since the buy back and issuing of new debt takes place at the end of the reporting period, so interest expenses is not changed for the reporting period.

=> The firm's EPS after buy back = 1,250,000/50,000 = $25.

So, EPS will increase double from $12.5 per share to $25 per share as the buying back takes place.