Hazlett's is an unlevered firm with a total market value of $280,000 and 10,000 shares of stock outstanding.The firm has expected EBIT of $16,000 if the economy is normal and $19,000 if the economy booms.The firm is considering a bond issue of $42,000 with an attached interest rate of 7.3 percent.The bond proceeds will be used to repurchase shares.The tax rate is 35 percent.What will be the earnings per share after the repurchase if the economy is normal?
A)$1.27
B)$0.63
C)$0.99
D)$1.05
E)$1.18

Question

Quizplus · Accepted Answer

First, we need to calculate the value of the firm before and after the bond issue.
Before the issue, the total market value is $280,000, and since there are no debts, the firm's enterprise value is also $280,000.
After the issue, the total market value is the sum of the market value of equity and debt, which is $280,000. The market value of equity is the total market value minus the bond issue, which is $238,000 ($280,000 - $42,000). The market value of debt is $42,000.
Next, we need to calculate the earnings before interest and taxes (EBIT) and the interest expense for both scenarios.
If the economy is normal, the EBIT is $16,000. The interest expense is $42,000 x 7.3% = $3,066. Therefore, the earnings before taxes (EBT) is $16,000 - $3,066 = $12,934. After taxes, the earnings available to equity is $12,934 x (1 - 0.35) = $8,421. The earnings per share is $8,421 / 10,000 = $0.8421.
If the economy booms, the EBIT is $19,000. The interest expense is the same, which is $3,066. Therefore, the EBT is $19,000 - $3,066 = $15,934. After taxes, the earnings available to equity is $15,934 x (1 - 0.35) = $10,352. The earnings per share is $10,352 / 10,000 = $1.0352.
Therefore, if the economy is normal, the earnings per share after the repurchase is $0.8421. The best choice is C.

Hazlett's Is an Unlevered Firm with a Total Market Value