Question

Your company doesn't face any taxes and has $256 million in assets, currently financed entirely with equity. Equity is worth $8.6 per share, and book value of equity is equal to market value of equity. Also, let's assume that the firm's expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities as shown below: State Pessimistic Optimistic Probability of State .30 .70 Expect EBIT in State $16 million $56 million The firm is considering switching to a 25-percent debt capital structure, and has determined that they would have to pay a 11 percent yield on perpetual debt in either event. What will be the level of expected EPS if they switch to the proposed capital structure? (Round your intermediate calculations and final answer to 2 decimal places except calculation of number of shares which should be rounded to nearest whole number.)

Answer 1

Expected EBIT is weighted (by probability) average of the EBIT undertwo scenarios.

Expected EBIT = (30% * $16 mil) + (70% * $56 mil) = 4.8 mil + 39.2 mil = $44 mil

25% debt capital structure means 25% of total assets will be financed via debt.

256 mil * 25% = $64 mil --> Debt taken.

Interest expense = $64 mil * 11% = $7.04 mil

Since there are no taxes,

Expected Net Income = Expected EBIT - Interest Expense = ($44 - $7.04)mil = $36.96 mil

Number of shares outstanding = 256 mil/$8.6 = 29.77 mil

Expected EPS = $1.24