Question

Your company has a 35% tax rate and has $515 million in assets, currently financed entirely with equity. Equity is worth $41.50 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	$65 million	$115 million	$185 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.)

a. $7.66

b. $23.33

c. $7.78

d. $4.83

Answer 1

No. of shares = (515*10^6)/41.5 = 12,409,638.55 shares

EBIT = [(0.25*65) + (0.5*115) + (0.25*185)]*10^6 = 120,000,000

Debt = 25% of total capital = 0.25*515,000,000 = 128,750,000

Interest = 8% of debt = 8% of 128,750,000 = 10,300,000

Profit before tax = EBIT - Interest

= 120,000,000 - 10,300,000 = 109,700,000

Profit after tax = (1-tax rate)*profit before tax

= (1-35%)*109,700,000

= 71,305,000

New no. of shares = (1-25%)*12,409,638.55 = 9,307,228.92

Thus EPS = 71,305,000/9,307,228.92

= 7.66

Thus the answer is option "a" $7.66