Question

Your company doesn't face any taxes and has $503 million in assets, currently financed entirely with equity. Equity is worth $40.30 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	Recession	Average	Boom
Probability of State	.25	.50	.25
Expect EBIT in State	$53 million	$103 million	$173 million

The firm is considering switching to a 25-percent debt capital structure, and has determined that they would have to pay a 8 percent yield on perpetual debt in either event. What will be the level of expected EPS if they switch to the proposed capital structure? (Round your intermediate calculations and final answer to 2 decimal places except calculation of number of shares which should be rounded to nearest whole number.)

Answer 1

Interest in all states = Interest Rate x Proportion of debt in assets

= 0.08 x [0.25 x $503 million] = 0.08 x $125.75 million = $10.06 million

No. of Shares Outstanding = Proportion of equity in assets/share price

= [0.75 x $503 million]/$40.30

= $377.25 million/$40.30 = 9,361,042.184, or 9,361,042 shares

EPS WITH 25% DEBT

State	Recession	Average	Boom
EBIT	$53,000,000	$103,000,000	$173,000,000
Less: Interest	$10,060,000	$ 10,060,000	$ 10,060,000
EBT	$42,940,000	$ 92,940,000	$162,940,000
Less:Taxes(@0%)	$ 0	$ 0	$ 0
Net Income	$42,940,000	$ 92,940,000	$162,940,000
EPS(=NI/No. of Shares)	$4.59	$9.93	$17.41

Expected EPS = [P_i x EPS_i]

= [$4.59 x 0.25] + [$9.93 x 0.50] + [$17.41 x 0.25]

= $1.15 + $4.96 + $4.35 = $10.46