Question

In: Finance

Firm A wants to finance $5 million to support its new strategic plan. The firm expects...

Firm A wants to finance $5 million to support its new strategic plan. The firm expects that it will be able to generate $2 million in EBIT in the first year of implementing the strategy. The current stock price of Firm A is $10 and it has 1 million shares outstanding. The firm expects that it will be able to borrow money at 7% annual interest. Tax rate is 30%.

Firm A considers raising the entire amount by issuing new shares.

  • How many new shares need to be issued? (4 points)
  • What is the level of EBT if the firm uses this financing method? (4 points)
  • How much interest does the firm need to pay in the first year? (3 points)
  • What is the level of net income (EAT) if the firm uses this financing method? (3 points)
  • What is the resulting EPS if the firm uses this financing method? (4 points)
  • Firm A also wants to consider combining debt and equity financing methods. If the firm goes for 20% debt and 80% equity to raise the target amount, what is the resulting EPS?

Solutions

Expert Solution

Finance required= $ 5 million
EBIT= $ 2 million
Current Stock Price= $ 10
Shares Oustanding= 1 million
Borrowing Rate= 7% per annum
Tax Rate= 30%
Firm A consider raising the entire amount by issuing new shares
a) How many new shares need to be issued ?
Ans:
Finance required= $ 5 million
Current Stock Price= $ 10 per share
New Shares to be issued= Finance required/ current stock price per share
New Shares to be issued= $ 5 million/ $ 10
New Shares to be issued= 0.5 million
b) What is the level of EBT if the firm uses this financing method?
EBT= EBIT- Interest
As financing made through issue of shares,thus there is no debt and no interest.
EBT= $ 2 million- 0
EBT= $ 2 million
c) How much interest does the firm need to pay in the first year?
As financing made through issue of shares,thus there is no debt and no interest.
Interest= $ 0
d) What is the level of net income (EAT) if the firm uses this financing method?
EAT= EBIT-Interest - Tax
EAT= $ 2 million -$ 0 - $ 2 million x 30%
EAT= $ 2 million -$ 0 - $ 0.6 million
EAT= $ 1.4 million
e) What is the resulting EPS if the firm uses this financing method?
EPS= Earning available to equity shareholder/ Total number of Outstanding Shares
EPS= $ 1.4 million/ (1 million+ 0.5 million)
EPS= $ 1.4 million/ (1.5 million)
EPS= $0.93
f) Firm A also wants to consider combining debt and equity financing methods.
If the firm goes for 20% debt and 80% equity to raise the target amount, what is the resulting EPS?
Total Finance required= $ 5 million
Debt= $ 5 X 20%= $ 1 million
Equity= $ 5 X 800%= $ 4 million
New Shares to be issued= Finance required/ current stock price per share
New Shares to be issued= $ 4 million/ $ 10
New Shares to be issued= 0.4 million
Total Shares outstanding= 1 million+ 0.4 million
Total Shares outstanding= 1.4 million
Interest= $ 1 miilion X 7%= $ 0.07 million
EBT = EBIT- Interest
EBT = $ 2 million- $ 0.07 million
EBT = $ 1.93 mill

jeff jeffy answered 1 year ago
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