Question

Your company doesn't face any taxes and has $511 million in assets, currently financed entirely with equity. Equity is worth $41.10 per share, and book value of equity is equal to market value of equity. Also, let's assume that the firm's expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities as shown below:

State	Recession	Average	Boom
Probability of State	.25	.50	.25
Expect EBIT in State	$61 million	$111 million	$181 million

The firm is considering switching to a 25-percent debt capital structure, and has determined that they would have to pay a 8 percent yield on perpetual debt in either event. What will be the level of expected EPS if they switch to the proposed capital structure? (Round your intermediate calculations and final answer to 2 decimal places except calculation of number of shares which should be rounded to nearest whole number.)

Answer 1

Solution:
	Expected EPS =$11.35
Working Notes:
	Interest cost in all cases = Interest rate x 25% x total assets
		=8% x (25% X $511,000,000)
		= $10,220,000
	No. of shares outstanding = 75% X Total assets / Market price per share
	=75% x $511,000,000/$41.10 = 9,324,817.51824
	=9,324,818 Shares
	EPS when in capital structure 25% is debt in each situation of economy
	State	Recession	Average	Boom
	EBIT	61,000,000	111,000,000	181,000,000
Less:	Interest	10,220,000	10,220,000	10,220,000
	EBT	50,780,000	100,780,000	170,780,000
Less:	Taxes @ 0%	0	0	0
	Net Income (EAT) (a)	50,780,000	100,780,000	170,780,000
	÷
	No. of shares (b)	9,324,818	9,324,818	9,324,818
	EPS (a/b)	5.45	10.81	18.31
	Probability	0.25	0.50	0.25
	Expected EPS = Sum of (EPS x Prob.)
	=5.45 x 0.25 + 10.81 x 0.50 + 18.31 x 0.25
	=11.345
	=$11.35
Please feel free to ask if anything about above solution in comment section of the question.