Question

Your company doesn't face any taxes and has $254 million in assets, currently financed entirely with equity. Equity is worth $8.4 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	.25	.75
Expect EBIT in State	$14 million	$54 million

The firm is considering switching to a 20-percent debt capital structure, and has determined that they would have to pay a 9 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

Interest in all states will be equal to 0.09 × (0.20 × $254,000,000) = $4,572,000, and

The number of shares outstanding will be equal to (0.80 × $254,000,000)/$8.4 = 24,190,476.

The EPS in each state of nature will be as shown:

  EPS WITH 20% DEBT

STATE PESSIMISTIC OPTIMISTIC

EBIT $14,000,000 $54,000,000

- Interest 4,572,000    4,572,000

EBT(= Net Income) $9,428,000 $49,428,000

EPS $0.39 $2.04

The expected EPS will be equal to (0.25 × $0.39) + (0.75 ×$1.09) = $1.70