Question

Ricalta Inc. earns a total of $500,000 before interest and taxes. Its total debt is $1,110,000 (costing 5%). It has 150,000 shares of common stock at $5 per share. The firm is considering reducing its debt by $450,000 by issuing an additional 90,000 shares of common stock. The firm is in the 35 percent tax bracket. Its earnings before interest and taxes will remain the same as the new capital structure will not impact the firm’s operations. Which of the following will be a consequence of the change in Ricalta’s capital structure?​

Answer 1

Answer:

Current Situation:

EBIT = $500,000

Debt = $1,110,000

Interest Expense = Debt * Cost of Debt
Interest Expense = $1,110,000 * 5%
Interest Expense = $55,500

EBT = EBIT - Interest Expense
EBT = $500,000 - $55,500
EBT = $444,500

Net Income = EBT * (1-tax)
Net Income = $444,500 * (1 - 0.35)
Net Income = $444,500 * 0.65
Net Income = $288,925

EPS = Net Income / Number of shares outstanding
EPS = $288,925 / 150,000
EPS = $1.93

Proposed Situation:

EBIT = $500,000

Debt = $1,110,000 - $450,000
Debt = $660,000

Interest Expense = Debt * Cost of Debt
Interest Expense = $660,000 * 5%
Interest Expense = $33,000

EBT = EBIT - Interest Expense
EBT = $500,000 - $33,000
EBT = $467,000

Net Income = EBT * (1-tax)
Net Income = $467,000 * (1 - 0.35)
Net Income = $467,000 * 0.65
Net Income = $303,550

EPS = Net Income / Number of shares outstanding
EPS = $303,550 / 240,000
EPS = $1.27

The Change in Capital Structure will reduce the EPS by $0.66 ($1.93 - $1.27)