Question

Fresh out of Harvard Business School, Joe Walker, the new CFO of Joe's Southern Cornbread Company, wants to shake things up at the sleepy little food company headquartered in Birmingham, Alabama. The firm is currently an all-equity firm because "that's the way we've always done it." Under pressure from a new group of major stockholders, however, Walker is considering acquiring some debt (leverage) in an effort to boost earnings per share. The company currently has 600 shares, but he is thinking about borrowing $6,000 at 10% per year and buying back 200 of those shares. Refer to the scenario above. What would the unleveraged and leveraged EPSs look like if EBIT were only $1,200? All-equity EPS = $2.00, leveraged-equity EPS = $1.50 All-equity EPS = $3.00, leveraged-equity EPS = $2.00 All-equity EPS = $2.00, leveraged-equity EPS = $3.00 All-equity EPS = $4.50, leveraged-equity EPS = $3.00

Answer 1

Answer is. All-equity EPS = $2.00, leveraged-equity EPS = $1.50

In this question, assuming there is no impact of taxes.

Earnings per Share = Net Income/Total Outstanding Shares.

Assuming tax rate = 0%, Earnings before tax = Earnings after tax

All-equity scenarios:

EBIT = $1200. Since there will be no interest expense, EBT = $1200

Number of shares outstanding = 600

Hence, EPS = $1200/600 = $2

Leveraged scenario.

In this scenario there will be an interest expense component as well.

Interest expense would be = $6000 * 10% = $600

EBT = EBIT - Interest Expense =$1200 - $600 = $600

Number of Shares now outstanding = Number of shares outstanding before debt - number of shares repurchased = 600 - 200 = 400

EPS = $600/400 = $1.5