Question

Reliable Toy Company is an all equity firm with $1,000,000 in assets. The CFO has predicted that EBIT will be $250,000 for next year. Reliable is thinking about levering the firm with a loan of $400,000 at 12% interest. The funds will be used to buy back Reliable’s shares at $50 per share. There are currently 20,000 shares outstanding and Reliable is in the 35% tax bracket.

What will net income be under the current structure? _____________

What will net income be under the proposed structure? _____________

What is earnings per share under the current structure? _____________

How many shares will Reliable be able to buy back? ____________

How many shares will be outstanding after the restructuring? ____________

What will earnings per share be under the proposed structure? ____________

Should Reliable do the restructuring or not? _______________

Answer 1

Answer

We will calculate Net Income (EAT) & EPS with the help of following table

		Current Structure	Proposed Structure
	EBIT (A)	250000	250000
	Interest (B)	0	48000
(A)-(B)	EBT (C )	250000	202000
	Tax (D) @35%	87500	70700
(C ) -(D)	EAT (E ) net income	162500	131300
	No. of Shares (F )	20000	12000
(E ) / (F )	Earning Per Share	8.125	10.94166667

• Net income in current structure = 162500
• Net income in proposed structure = 131300
• Earning per share in current strucure = 8.125
• No. of share buy back = 400000/50 = 8000
• No. of outstanding share = 20000-8000 = 12000
• Earning per share in proposed structure = 10.94166
• Restructring shall be done as EPS has increased in proposed structure