Question

Reliable Gearing currently is all-equity-financed. It has 18,000 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 $280,000 with the proceeds used to buy back stock. The high-debt plan would exchange $480,000 of debt for equity. The debt will pay an interest rate of 12%. The firm pays no taxes.

A. What will be the debt-to-equity ratio if it borrows $280,000?
B. If earnings before Interest and tax (EBIT) are $190,000, what will be earnings per share (EPS) If Reliable borrows $280,000?
C. What will EPS be if it borrows $480,000?

Answer 1

A. What will be the debt-to-equity ratio if it borrows $280,000?

• 18.42%

B. If earnings before Interest and tax (EBIT) are $190,000, what will be earnings per share (EPS) If Reliable borrows $280,000?

• $10.29

C. What will EPS be if it borrows $480,000?

• $10.03

Step-by-step explanation:

18,000 stocks at $100 per stock = $1,800,000

two debt plans both pay 12% interest, no taxes:

• low-debt, $280,000 used to buy back stocks
• high debt, $480,000 used to buy back stocks

debt to equity ratio = debt / equity

low debt ⇒ $280,000 / $1,520,000 = 18.42%

EBIT = $190,000 - ($280,000 x 12%) = $156,400

EPS = $156,400 / 15,200 stocks = $10.29

EBIT = $190,000 - ($480,000 x 12%) = $132,400

EPS = $132,400 / 13,200 stocks = $10.03