You work for the CEO of a new company that plans to manufacture and sell a new type of laptop computer.The issue now is how to finance the company,with only equity or with a mix of debt and equity.Expected operating income is $690,000.Other data for the firm are shown below.How much higher or lower will the firm's expected EPS be if it uses some debt rather than only equity,i.e. ,what is EPS_L - EPS_U? $\begin{array}{lrr}&0 \% \text { Debt, U }&60 \% \text { Debt, L }\\\hline\text { Oper. income (EBIT) } & \$ 690,000 & \$ 690,000 \\\text { Required investment } & \$ 2,500,000 & \$ 2,500,000 \\\% \text { Debt } & 0.0 \% & 60.0 \% \\\$ \text { of Debt } & \$ 0.00 & \$ 1,500,000 \\\$ \text { of Common equity } & \$ 2,500,000 & \$ 1,000,000 \\\text { Shares issued, } \$ 10 \text { share } & 250,000 & 100,000 \\\text { Interest rate } & \text { NA } & 10.00 \% \\\text { Tax rate } & 35 \% & 35 \%\end{array}$
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Question

You work for the CEO of a new company that plans to manufacture and sell a new type of laptop computer.The issue now is how to finance the company,with only equity or with a mix of debt and equity.Expected operating income is $690,000.Other data for the firm are shown below.How much higher or lower will the firm's expected EPS be if it uses some debt rather than only equity,i.e. ,what is EPS_L - EPS_U?

\begin{array}{lrr}&0 \% \text { Debt, U }&60 \% \text { Debt, L }\\\hline\text { Oper. income (EBIT) } & \$ 690,000 & \$ 690,000 \\\text { Required investment } & \$ 2,500,000 & \$ 2,500,000 \\\% \text { Debt } & 0.0 \% & 60.0 \% \\\$ \text { of Debt } & \$ 0.00 & \$ 1,500,000 \\\$ \text { of Common equity } & \$ 2,500,000 & \$ 1,000,000 \\\text { Shares issued, } \$ 10 \text { share } & 250,000 & 100,000 \\\text { Interest rate } & \text { NA } & 10.00 \% \\\text { Tax rate } & 35 \% & 35 \%\end{array}

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Quizplus · Accepted Answer

First, calculate the net income for both scenarios (0% Debt, U and 60% Debt, L):For 0% Debt (U):- EBIT = $690,000- Interest = $0 (since there's no debt)- EBT (Earnings Before Taxes) = EBIT - Interest = $690,000- Taxes (35%) = $690,000 * 0.35 = $241,500- Net Income = EBT - Taxes = $690,000 - $241,500 = $448,500- EPS (Earnings Per Share) = Net Income / Shares = $448,500 / 250,000 = $1.794For 60% Debt (L):- EBIT = $690,000- Interest = $1,500,000 * 0.10 = $150,000- EBT = EBIT - Interest = $690,000 - $150,000 = $540,000- Taxes (35%) = $540,000 * 0.35 = $189,000- Net Income = EBT - Taxes = $540,000 - $189,000 = $351,000- EPS = Net Income / Shares = $351,000 / 100,000 = $3.51Difference in EPS (EPS_L - EPS_U) = $3.51 - $1.794 = $1.716Therefore, the EPS is $1.72 higher with some debt compared to only equity.

You Work for the CEO of a New Company That