Question

Your company doesn't face any taxes and has $510 million in assets, currently financed entirely with equity. Equity is worth $41.00 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 | Recession | Average | Boom |

Probability of State | .25 | .55 | .20 |

Expect EBIT in State | $60 million | $110 million | $180 million |

The firm is considering switching to a 15-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.)

$9.75

$10.24

$16.23

$30.72

Answer #1

State | Probability (i) | Expected EBIT (ii) | Product (i) x (ii) |

Recession | 0.25 | $60 million | $15 million |

Average | 0.55 | $110 million | $60.5 million |

Boom | 0.20 | $180 million | $36 million |

total | $111.5 million |

Hence, expected EBIT is $111.5 million

Current investment in assets = $510 million

Proposed debt financing = 15%

=510 x 15%

= $76.5 million

Interest on debt = 11%

= 76.5 x 11%

= $8.415 million

Hence, equity financing = 510 - 76.5

= $433.5 million

Book value of 1 share = $41

Hence, number of outstanding shares = 433.5 x 1,000,000/41

= 10,573,171

Earnings after interest = EBIT - Interest

= 111.5 - 8.415

= $103.085 million

EPS = Earnings after interest/Number of outstanding shares

= 103.085 x 1,000,000/10,573,171

= $9.75

Hence, correct option is (a)

Kindly give a positive rating if you are satisfied with the answer. Feel free to ask if you have any doubts. Thanks.

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