Question

Reliable Gearing currently is all-equity-financed. It has 17,000 shares of equity outstanding, selling at $100 a share. The firm is considering a capital restructuring. The low-debt plan calls for a debt issue of $270,000 with the proceeds used to buy back stock. The high-debt plan would exchange $470,000 of debt for equity. The debt will pay an interest rate of 11%. The firm pays no taxes.

Required:
a. What will be the debt-to-equity ratio if it borrows $220,000?
b. If earnings before interest and tax (EBIT) are $130,000, what will be earnings per share (EPS) if Reliable borrows $220,000?
c. What will EPS be if it borrows $420,000?

Answer 1

a. 0.15

b. $7.15 per share

c. $6.55

Step-by-step explanation:

a. What will be the debt-to-equity ratio if it borrows $220,000?

Market value of equity = 17,000 * $100 = $1,700,000

Since the proceeds of a debt issue of $270,000 is used to buy back stock, we have:

Remaining market value of equity = $1,700,000 - $220,000 = $1,480,000

Therefore,

Debt-to-equity ratio = Debt / Remaining market value of equity = $220,000 / $1,480,000 = 0.15.

b. If earnings before interest and tax (EBIT) are $130,000, what will be earnings per share (EPS) if Reliable borrows $220,000?

Remaining number of shares = Remaining market value of equity / Market price per share = $1,480,000 / $100 = 14,800 shares

Interest on debt = $220,000 * 11% = $24,200

Tax = $0

Earning after interest and tax = EBIT - Interest on debt - Tax = $130,000 - $24,200 - $0 = $105,800

EPS = Earning after interest and tax / Remaining number of shares = $105,800 / 14,800 = $7.15 per share

c. What will EPS be if it borrows $420,000?

Remaining number of shares = ($1,700,000 - $420,000) / $100 = 12,800 shares

Interest on debt = $420,00 * 11% = $46,200

Tax = $0

Earning after interest and tax = EBIT - Interest on debt - Tax = $130,000 - $46,200 - $0 = $83,800

EPS = Earning after interest and tax / Remaining number of shares = $83,800 / 12,800 = $6.55 per share