Question

Jr Computers, a firm that manufactures and sell personal computers, is an all-equity firm with 1000,000 shares outstanding, $10 million in earnings after taxes, and a market value of $150 million. Assume that this firm borrows$60 million at an interest rate of 8% and buys back 40,000 shares, using funds. If the firm’s tax rate is 50%

a. The effect on earnings per share of the action

b. What the interest rate on the debt would have to be for the earnings per share effect to disappear

Answer 1

	Currently without debt	After debt and buy back
Ans a	Particulars	Amount in $	Particulars	Amount in $
	Earning after tax	10,000,000.00	Earning before interest and tax	20,000,000.00
	No. of shares outstanding	1,000,000.00	Interest	4800000	(60000000*8%)
	EPS	10.00	Earning before tax	15,200,000.00
			tax@50%	7,600,000.00
			Earning after tax	7,600,000.00
			No. of shares outstanding	960,000.00	(1000000-40000)
			EPS	7.92
Ans b	For effect on EPS to disappear, EPS must be same as before:
a	Required EPS	10.00
b	Required earnings after tax	9,600,000.00	(960000 shares*10)
c	tax@50%	9,600,000.00
d	Required earnings before tax (b+c)	19,200,000.00
e	Actual earnings before interest and tax	20,000,000.00
f	Interest amount (e-d)	800,000.00
g	Interest rate should be	1.33%	(800000/60000000)