Question

Use the following information to answer the questions below.

	Current cap. structure	Proposed cap. structure
Assets	$20 million	$20 million
Debt	$0	$5 million
Equity	$20 million	$15 million
Share price	$40.00	$37.50
Shares outstanding	500,000	???
Bond coupon rate	N/A	5%

Assume that there are no taxes. EBIT is expected to be $2.5 million, but could be as high as $3.5 million if an economic expansion occurs, or as low as $2 million if a recession occurs. All values are market values.

1. How many shares are outstanding under the proposed capital structure?

2. What is the expected EPS under the current capital structure if there is a recession?

3. What is ROE for the proposed capital structure if the expected state occurs?

4. Which of the following is the correct calculation to find EBIT*, the breakeven EBIT

       for these two capital structures?

EBIT*/500,000 = [EBIT*-($15,000,000x.05)]/600,000

EBIT*/500,000 = [EBIT*-($5,000,000x.05)]/400,000

              C)    [EBIT*-($6,000,000x.05)]/500,000 = EBIT*/500,000

[EBIT*-($5,000,000x.05)]/500,000 = EBIT*/400,000

Answer 1

Proposed Capital Structures:

1. Market Price per Share = $37.50

Total Equity Requirement= $15million

Total number of shares outstanding = $15million/ $37.50= 4, 00,000 shares

2. If there is a recession, EBIT will be $2million

Interest on Debt will be = Debt Value * Coupon rate = $5*5% = $0.25million

So Profit before taxes = EBIT (-) Interest = $2-$0.25 = $1.75million

Since taxes are nil so Profit after taxes are same as profit before taxes so, Net income = $1.75million

EPS = Net Income/ No. of shares outstanding = $1.75/400,000= $4.375

3. If the expected state occurs, EBIT will be $2.5 million

Interest on Debt will be = Debt Value * Coupon rate = $5*5% = $0.25million

So Profit before taxes = EBIT (-) Interest = $2.5-$0.25 = $2.25million

Since taxes are nil so Profit after taxes are same as profit before taxes so, Net income = $2.25 million

Return on Equity = Net Income / Total Equity*100

Or, Return on Equity = $2.25/ $15*100= 15%

4. To find the break-even EBIT, for these 2 capital structures would be:

(EBIT- interest)* (1-Taxes)/ 500,000= (EBIT- interest)* (1-Taxes)/ 400,000

Or, EBIT/ (500,000) = [EBIT- (50, 00,000*0.05)]/(400,000)

So option (b) is correct

Note: since there is an absence of “interest” and “taxes” so EBIT and Net Income after deduction of interest and taxes remains same.