Question

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.)

Answer 1

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