Question

# Reliable Gearing currently is all-equity-financed. It has 25,000 shares of equity outstanding, selling at \$100 a...

Reliable Gearing currently is all-equity-financed. It has 25,000 shares of equity outstanding, selling at \$100 a share. The firm is considering a capital restructuring. The low-debt plan calls for a debt issue of \$350,000 with the proceeds used to buy back stock. The high-debt plan would exchange \$550,000 of debt for equity. The debt will pay an interest rate of 10%. The firm pays no taxes.

a. What will be the debt-to-equity ratio if it borrows \$350,000? (Round your answer to 2 decimal places.)

b. If earnings before interest and tax (EBIT) are \$260,000, what will be earnings per share (EPS) if Reliable borrows \$350,000? (Round your answer to 2 decimal places.)

c. What will EPS be if it borrows \$550,000? (Round your answer to 2 decimal places.)

Solution:

a)Calculation of debt-to-equity ratio

Market value of debt=\$350,000

Market value of equity after issue of debt=(25,000*\$100)-\$350,000

=\$2150,000

Debt-to Equity Ratio=Debt/Equity

=\$350,000/\$2150,000

=0.16:1

b)Calculation of EPS

Earning avialable for equity shareholder=EBIT-INterest

=\$260,000-(\$350,000*10%)

=\$225,000

No. of equity shares after buy back=\$2150,000/\$100

=21,500 shares

EPS=Earning avialable for equity shareholder/No. of equity shares after buy back

=\$225,000/21,500

=\$10.47

c)No. of share buyback=Amount borrowed/Price per share

=\$550,000/\$100

=5500 shares

No. of shares left after buy back=25000-5500=19500 shares

EPS=Earning avialable for equity shareholder/No. of equity shares after buy back

=\$260,000-(\$550,000*10%)/19,500 shares

=\$10.51

#### Earn Coins

Coins can be redeemed for fabulous gifts.