Question

Rising Tide, Inc. has no debt outstanding, and its financial position is given by the following data:

Assets (market value = book value) $6,500,000

EBIT $800,000

Cost of equity 8%

Stock price $16

Shares outstanding 406,250

Tax rate 35%

The firm is considering selling bonds and simultaneously repurchasing some of its stock. If it moves to a capital structure with 20% debt based on market values, its cost of equity will increase to 9% to reflect the increased risk. Bonds can be sold at a cost of 5%. Rising Tide is a no-growth firm. Hence, all its earnings are paid out as dividends. Earnings are expected to be constant over time.

a. If the company does the proposed leveraged recapitalization, what will be the new earnings per share?

b. As a creditor, you are concerned about the company’s ability to repay its debt and interest. What is the new times interest earned?

Answer 1

a. Total assets = 6,500,000

So, new debt is issued = 20% * 6,500,000 = 1,300,000

Number of shares to be repurchased = 1,300,000/16 = 81,250

New total number of shares = 406,250 - 81,250 = 325,000

EBIT = 800,000

Interest = 1,300,000 *0.05 = 65,000

EBT = 735,000

Taxes = 0.35* 735,000 = 257,250

Net Income = 477,750

New Earnings per share = 477,750/325,000 = $1.47/share

New Earnings per share = $1.47

b. New Times Interest earned = EBIT/ Interest expense = 800,000/65,000 = 12.31

New Times Interest earned = 12.31