Question

Jackson Software, Inc. is an all-equity firm with 2 million shares outstanding, $6 million in earnings after taxes, and a market value of $100 million. The firm borrows $25 million at an interest rate of 8% and buys back 500,000 shares with the proceeds. The firm's tax rate is 40%. Management does not want the earnings performance to disappoint shareholders and market analysts. What is the maximum interest rate the firm could pay on its new debt so as not to experience a decrease in earnings per share after the stock repurchase?

Select one:

A. 8.00%

B. 10.00%

C. 11.50%

D. 12.60%

E. None of the above

Answer 1

Current earnings per share = Current earnings after taxes / Current no. of shares = $6,000,000 / 2,000,000 = $3 per share

This earnings per share has to be maintained.

New no. of shares = 2,000,000 - 500,000 = 1,500,000

New earnings per share = Old earnings per share

or, New earnings after tax / New no. of shares = $3

or, New earnings after tax = $3 x New no. of shares = $3 x 1,500,000 = $4,500,000

Reduction in earnings after tax that firm can bear = $6,000,000 - $4,500,000 = $1,500,000

This is the amount of interest but this is after tax. So -

Before tax interest amount = $1,500,000 / (1 - tax rate) = $1,500,000 / (1 - 0.40) = $2,500,000

Interest rate = (Before tax Interest / borrowing) x 100 = ($2,500,000 / $25,000,000) x 100 = 10%

Therefore, the firm can pay a maximum of 10% interest rate on its debt without experiencing a decrease in earnings per share.