Question

Your company is an all-equity firm and has 1 million shares outstanding and its current market value is $10 million, with an operating income (EBIT) is $1.5 million. This morning your company issued $2 million of debt at a 10% coupon rate and used the proceeds to repurchase your company’s shares from the stock market. The transaction is completed before the end of the day. Your company’s cost of capital is 6% and the corporate income tax rate is 20%.

(a) What is the company’s earnings-per-share before the repurchase?

(b) How many shares of your company’s stock are repurchased on this morning?

(c) What is the company’s earnings-per-share (EPS) after the repurchase?

Answer 1

No of shares outstanding of all equity firm = 1 million

EBIT = $1.5 million

Since, the company is all eqity it will not have any Interest Expenses

Net Income = EBIT(1-Tax Rate)

= $1.5 million(1-0.20)

= $ 1.2 million

EPS = Net Income/No of shares outstanding

= $1.2 million/1 million

= $ 1.2 per share

So, EPS before purchase is $ 1.2 per share

b). No of shares outstanding of all equity firm = 1 million

Current market value before repurchase = $10 million

Per share Market value = $10 million/1 million

= $ 10 per share

Company issued $ 2 million of debt and uses the proceeds to repirchase the shares

No of shares repurchase = Debt amount issued/Market price per share

= $2 milliom/$10

= 200,000 shares

So, no of shares repurchased are 200,000

c). No of shares outstanding after repurchase = 1,000,000 - 200,000

= 800,000

Interest Expense on debt = $ 2 million*10%

= $200,000

Net Income = [EBIT- Interest Expense](1-Tax Rate)

= [$ 1,500,000 - $200,000](1-0.20)

= $1040,000

EPS = Net Income/No of shares outstanding

= $1040,000/800,000

= $ 1.3 per share

So, EPS after repurchase is $ 1.3 per share

If you need any clarification, you can ask in comments.     

If you like my answer, then please up-vote as it will be motivating