Question

Daddi Mac, Inc. doesn’t face any taxes and has $285.60 million in assets, currently financed entirely with equity. Equity is worth $34 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 0.25 0.55 0.20 Expected EBIT in state $ 6,279,000 $ 11,256,000 $ 18,312,000. The firm is considering switching to a 25-percent-debt capital structure and has determined that it would have to pay an 8 percent yield on perpetual debt in either event. What will be the level of expected EPS if the firm switches to the proposed capital structure?

Answer 1

Existing capital structure	No debt
Total capital	285600000
Equity 100%	285600000
Debt 0%	0
Economic condition	Recession	Average	Boom
Probability of state	0.25	0.55	0.2
EBIT	6279000	11256000	18312000
Less: Interest	0	0	0
Profit Before Tax PBT	6279000	11256000	18312000
Less: Tax	0	0	0
Profit After Tax (PAT)	6279000	11256000	18312000
No of shares = Equity/book value	8400000	8400000	8400000
Book value is $34
Earnings Per share = PAT/No of shares	0.75	1.34	2.18

When the capital structure is modified, the expected EPS will be:

New capital structure	25% debt
Total capital	285600000
Equity 75%	214200000
Debt 25%	71400000
Economic condition	Recession	Average	Boom
Probability of state	0.25	0.55	0.2
EBIT	6279000	11256000	18312000
Less: Interest @8%	5712000	5712000	5712000
Profit Before Tax PBT	567000	5544000	12600000
Less: Tax	0	0	0
Profit After Tax (PAT)	567000	5544000	12600000
No of shares = Equity/book value	6300000	6300000	6300000
Book value is $34
Earnings Per share = PAT/No of shares	0.09	0.88	2

When the capital structure is modified, the earnings per share decreases in all economic conditions.