Question

Sewer's Paradise is an all equity firm that has 5,000 shares of stock outstanding at a market price of $15 a share. The firm's management has decided to issue $30,000 worth of debt and use the funds to repurchase shares of the outstanding stock. The interest rate on the debt will be 10 percent. What are the earnings per share at the break-even level of earnings before interest and taxes? Ignore taxes.

Multiple Choice

• $1.46

• $1.50

• $1.67

• $1.88

• $1.94

Answer 1

The break even level of EPS is computed as shown below:

EBIT / 5,000 = (EBIT - interest) / Number of shares

Number of shares will be as follows:

= Existing shares - Amount of debt / Per share value

= 5,000 - $ 30,000 / $ 15

= 3,000

EBIT / 5,000 = (EBIT - $ 30,000 x 10%) / 3,000

EBIT / 5,000 = (EBIT - $ 3,000) / 3,000

3,000 EBIT = 5,000 EBIT - $ 15,000,000

EBIT = $ 15,000,000 / 2,000

EBIT = $ 7,500

So, the EPS will be as follows:

= (EBIT - Interest) / Number of shares outstanding

= ($ 7,500 - $ 30,000 x 10%) / 3,000

= $ 1.50

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