Question

Classy Office Supplies Inc. is an all equity firm with $2,000,000 in equity. It has been suggested that they borrow $900,000 at 8% and use it to buy back shares of their own stock, thereby changing their capital structure. There are 50,000 shares outstanding and they currently sell for $40/share. EBIT is expected to be $1,000,000 next year. Classy is in the 21% tax bracket. What is the EPS under the current structure? How many shares will Classy be able to buy back? How many shares will Class have outstanding after the restructuring? What will the earnings per share be under the proposed structure? Should Classy do the restructuring?

Answer 1

EPS = Earning per share = Profit after tax / no of shares outstanding

Profit after tax = EBIT * ( 1 - Tax rate ) as there is no interest in current structure

=1000000 *( 1 - 0.21)

= $790,000

EPS under the current structure= 790000 / 50000 = $15.80

No of shares Classy will be able to buy back = Amount borrowed as debt / current market price

= 900000 / 40 = 22500

No of shares Classy will be have after the restructuring = 50000 - 22500 = 27,500

Profit after Tax after the restructure = EBIT - Interest - Tax =

Interest on debt = Debt amount * interest rate = 900000 * 8% = 72000

PAT after restructure = 1000000 - 72000 - 0.21* ( 1000000 -72000)

= $733,120

EPS under proposed structure = 733120 / 27500 = $26.66