Paradise Travels is an all-equity firm that has 9,000 shares of stock outstanding at a market price of $27 a share. Management has decided to issue $25,000 worth of debt and use the funds to repurchase shares of the outstanding stock. The interest rate on the debt will be 7.3 percent. What are the earnings per share at the break-even level of earnings before interest and taxes? Ignore taxes.

Question

Quizplus · Accepted Answer

To find the break-even level of EBIT, we need to calculate the level of EBIT at which the interest expense equals the earnings from the repurchased shares:

$25,000 × 0.073 = $1,825 interest expense on debt
$1,825 ÷ 9,000 = $0.2039 earnings per share from repurchased shares

At the break-even level of EBIT, the total earnings per share will be equal to the earnings per share from the repurchased shares, since interest expense will have consumed all the earnings from the remaining shares. Therefore:

EPS = $0.2039
EBIT = interest expense ÷ interest rate
EBIT = $1,825 ÷ 0.073
EBIT = $25,000

Now we can calculate the earnings per share at the break-even level of EBIT:

EPS = (EBIT - Interest Expense) ÷ Number of Shares
EPS = ($25,000 - $1,825) ÷ 9,000
EPS = $2.1944

Therefore, the answer is B) $1.97, rounded to the nearest cent.

Paradise Travels Is an All-Equity Firm That Has 9,000 Shares