Question

Conservative Company has no debt. The amount of equity and assets are $900,000. There are 30,000 shares outstanding. The book value and market value of the shares are the same: $30. A new board member has suggested that changing the capital structure to include some debt might be a good idea. The CFO has come up with the following data: Most likely EBIT for next year $450,000 Amount of Proposed Loan $225,000 Interest Rate on Loan 8% Tax Rate 21% Compute the earnings per share under each structure. ROE under current structure ______________ ROE under proposed structure ____________ Should Conservative do the restructuring? ________________ (Yes or No)

Answer 1

There are two structures: Under Current structure, the Company has no debt and under proposed structure, the company has proposed to take loan of $ 225000 @ 8%.

Computation of EPS:

EPS = Earnings attributable to equity shareholders/No. of Shares outstanding

Particulars	Current structure ($)	Proposed structure ($)
Earnings before interest and taxes (EBIT)	450000	450000
Less: Interest	-	(18000)
Earnings before tax (EBT)	450000	432000
Less: Taxes @ 21%	94500	90720
Earnings after tax (EAT)	355500	341280

EPS under Current structure:

EPS = 355500/30000 = $ 11.85 per share

EPS under proposed structure:

EPS = 341280/30000 = $ 11.38 per share

ROE under current structure:

ROE = $355500/$900000*100 = 39.50%

ROE under proposed structure:

ROE = $341280/$900000*100 = 37.92%

Since the EPS and ROE are reduced in proposed structure, therefore restructuring is not conservative.