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?

      
EPS decreases by 6.7% to $11.67.

       
EPS increases by 20% to $15.00.

EPS increases by 80% to $22.50.

       
EPS decreases by 33.3% to $10.00.

Answer 1

Interest rate on debt = $250000/$5000000
	=5%
	Present	Proposed
EBIT	$       15,00,000	$       15,00,000
Less:
Interest	$          2,50,000	$          3,75,000
		($7500000*5%)
tax	0	0
Income AfterTax	$       12,50,000	$       11,25,000
Number of shares outstanding	100000	50000
EPS	$                12.50	$                22.50
Changes in EPS = ($22.50-12.50)/12.50 =80%
New EPS = $22.50
Correct Option: THIRD