Question

GTB, Inc., has a 25 percent tax rate and has $67.92 million in assets, currently financed entirely with equity. Equity is worth $6 per share, and book value of equity is equal to market value of equity. Also, let’s assume that the firm’s expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities as shown below:

    

State	Pessimistic				Optimistic
Probability of state		0.40				0.60
Expected EBIT in state	$	4,018,600			$	16,244,200

    

The firm is considering switching to a 25-percent-debt capital structure, and has determined that it would have to pay a 9 percent yield on perpetual debt in either event. What will be the level of expected EPS if GTB switches to the proposed capital structure? (Do not round intermediate calculations and round your final answer to 2 decimal places.)

  

Expected EPS

$

Answer 1

Interest in all states will be equal to 0.09 × (0.25 × $67,920,000) = $1,528,200, and the number of shares outstanding will be equal to (0.75 × $67,920,000)/$6 = 8,490,000

Pessimistic State:
EBIT = 4,018,600
Interest = 1,528,200
EBT = 2,490,400
Taxes(@25%) = 622,600
Net Income = 1,867,800
EPS = 1,867,800/8,490,000 = 0.22

Optimistic State:
EBIT = 16,244,200
Interest = 1,528,200
EBT = 14,716,000
Taxes(@25%) = 3,679,000
Net Income = 11,037,000
EPS = 11,037,000/8,490,000 = 1.30

Expected EPS = 0.22 x 0.4 + 1.30 x 0.6 = 0.87