Question

Your company is considering a recapitalization plan that would convert it from its current all-equity capital structure to one including financial leverage. Your company now has 10000,000 shares of ordinary shares outstanding, which are selling at R40 each. You expect the company's EBIT to be R50,000,000 per year, for the foreseeable future.

The recapitalization proposal is to issue R100,000,000 worth of long-term debt, at an interest rate of 6.50%, and use the proceeds to repurchase as many shares as possible, at a price of R40 per share. Assume there are no market frictions such as corporate or personal income taxes.

Required:

1. calculate the number of shares outstanding, the per share price, and the debt-to-equity ratio for the company, if it adopts the proposed recapitalization.

2. calculate the earnings per share(EPS) and the return on equity for the company shareholders, under both the current-equity capitalization and the proposed mixed debt/equity capital structure.

3. calculate the break-even level of EBIT, where earnings per share for the shareholders are the same, under the current and proposed capital structures.

4. at what level of EBIT will your company shareholders earn zero EPS under the current and proposed capital structures?

Answer 1

Please refer to below spreadsheet for calculation and answer(1,2,4). Cell reference also provided.

Cell reference -

3. Break even level of EBIT for EPS between Current and Proposed capital Structure

Break even level of EBIT is a amount of EBIT at which EPS in both cases remains same. we express this with following equation -

Thus, Break even level of EBIT = 26,000,000

Hope this will help, please do comment if you need any further explanation. Your feedback would be appreciated.