Question

North Side, Inc. has no debt outstanding and a total market value of $168,000. Earnings before interest and taxes, EBIT, are projected to be $18,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be $21,960 . The company is considering a $50,000 debt issue with an interest rate of 7.4 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,000 shares outstanding and the tax rate is 21 percent. What is the EPS for each capital structure under each scenario? If we ignore taxes, what is the break-even EBIT?

Answer 1

	NORMAL	STRONG EXPANSION
EBIT	18000	21960
Less:Interest	(3700)	(3700)            [50000*7.4%]
EBT	14300	18260
Less:Taxes	(3003)   [14300*.21]	(3834.6)          [18260*.21]
Net Income	11297	14425.4
Number of shares outstanding	3511.90	3511.90
EPS	11297/3511.9 =$ 3.22 per share	14425.4/3511.90 =$ 4.11 per share

Working:

Share price =Total market value /number of shares outstanding

              = 168000/5000

                = $ 33.6 per share

Number of shares repurchased from amount received from debt issue = Total debt /current share price per share

                                                                                     = 50000/33.6= 1488.10

shares after repurchase = 5000-1488.10 = 3511.90

b)There are no taxes.

Alternative I ,Earning per share = EBIT /number of shares outstanding    [Before repurchase]

Alternative II ,earning per share =[EBIT- interest ]/Number of shares outstanding after repurchase.

At breakeven Earning per share under both alternative are equal.

EBIT /5000 = [EBIT-3700]/3511.90

3511.90 *EBIT /5000 = EBIT -3700

   .70238 EBIT = EBIT -3700

      EBIT -.70238 EBIT = 3700

           .29762 EBIT = 3700

               EBIT = 3700/.29762

                        = 12431.96   (rounded to 12432 )

Breakeven EBIT = 12432