Question

JohnSmith Engineering is currently unlevered with 2,000 shares outstanding and assets valued at $50,000. The company expects operating income(EBIT) in the current period to be $4,000. Suppose that the company can exchange 400 shares of stock for $10,000 in debt paying 10% interest. Assume no taxes. a. From the standpoint of EPS, would the exchange be wise? b. What is the break-even EBIT?

Answer 1

ANSWER DOWN BELOW. FEEL FREE TO ASK ANY DOUBTS. THUMBS UP PLEASE.

a. Number of shares outstanding = 2000

Earnings before interest and tax = Earnings available to shareholders =4000

Old EPS = 4000/2000 = 2

New number of shares outstanding = (2000-400)

EBIT = 4000
INTEREST EXPENSE = 10000 X 10% = 1000
Earnings available to shareholders = (4000-1000)

EPS = (4000-1000)/(2000-400)
New EPS = 1.875

From, EPS Standpoint: The exchange is not wise. (Answer)

b. Break even Earnings before interest and tax = INTEREST EXPENSE = 10000 X 10% = 1000

Answer: 1000