Question

Donaldsen International is an all-equity firm with a current share price of $12.50 and 10,000 shares outstanding. Management is considering issuing $50,000 of debt at an interest rate of 6.5 percent and using the proceeds to repurchase shares. It is felt that the company will have earnings before interest and taxes (EBIT) of $30,000. The company tax rate is 30%. What will the earnings per share (EPS) be if the debt is issued?

You are comparing two financial policies. The first is all equity. The second involves the use of $2 million of debt. The break-even point between these two policies occurs when the earnings before interest and taxes (EBIT) is $450,000. Given this, it is accurate to say that leverage _____ beneficial to the firm when EBIT is $325,000 and _____ beneficial when EBIT is $625,000.

A company has 400,000 shares outstanding at a market price of $6 each. The company also has 20,000 bonds outstanding each with a face value of $100, and a market price of $113.

What is the firm's equity ratio?

Answer 1

Donaldsen International                              

• Share Price, P, $ 12.5
• Shares outstanding 10,000
• New Debt, $                               50,000   to repurchase shares
• Interest rate 6.5%
• EBIT, $                                       30,000
• Tax rate                                      0%

In all-equity firm, there are no interest costs, thus

Net income (all-equity) = (EBIT – Interest)*(1-tax rate)

                                                = (30,000 – 0)*(1-30%)

                                                = 30,000 * 70%

                                                = 21,000

EPS (all-equity)                 = Net income (all-equity) / Shares outstanding

                                                = 21,000 / 10,000

                                                = 2.1

If debt is raised, then

Net income (with debt)                = (EBIT – Interest)*(1-tax rate)

                                                = (30,000 – 6.5%*50,000)*(1-30%)

                                                = (30,000 – 3250)*(70%)

                                                = 18,725

Shares repurchased using $50,000            = Debt raised / Share price

                                                                                = 50,000 / 12.5

                                                                                = 4000

Thus, shares remaining after repurchase              = 10,000-4,000   = 6,000

EPS (with debt) = Net income (with debt) / Shares outstanding

                                = 18,725 / 6000

                                = 3.12

Thus, EPS will increase from 2.1 to 3.12 if debt of $50,000 is raised to repurchase shares

2 financial policies

All equity vs $2 mn debt

In an all equity firm, there are no interest costs thus EBIT is reduced by just the taxes involved to arrive upon the net income figure.

In a firm with debt, interest costs initially reduce EBIT before the effect of tax kicks in to arrive upon the net income figure. Since taxes reduce by the interest deductible in a firm with debt, the net reduction in net income for a firm with debt is equal to net income (all equity) minus the after tax cost of debt.

The break-even point or the point when net income =0 occurs when Interest costs = EBIT which in this case is $450,000. If EBIT is lower than this figure of $450,000, then there is negative profit causing lowering of equity in the firm. But if the EBIT is above $450,000, then the tax outgo reduces to the extent of tax *interest cost and there is positive net profit and positive impact on equity value.

Thus, it is accurate to say that leverage is not beneficial to the firm when EBIT is $325,000 is beneficial when EBIT is $625,000

Equity ratio

Market value of equity = shares outstanding * market price per share

                                                = 400,000*6

                                                =$2,400,000

Market value of debt     = bonds outstanding * market price per bond

                                                = 20,000*113

                                                = $2,260,000

Total value of the firm   = market value of equity + market value of debt

                                                = 2,400,000 + 2,260,000

                                                = $4,660,000

Equity ratio of the firm = market value of equity / total value of the firm

                                                = 2,400,000 / 4,660,000

                                                = 0.52

The firm’s equity ratio is 0.52