An all-equity firm as operating income of $1.5 million and EPS of $2. If you ignore taxes, and if $1 million of 20% debt were issued with the proceeds used to repurchase two-thirds of the outstanding shares of stock, then the firm's EPS would:

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The current number of outstanding shares can be calculated by dividing the operating income by the EPS, so it is 1.5 million / 2 = 0.75 million shares. With $1 million of 20% debt, the interest expense would be $200,000, leaving $800,000 to repurchase two-thirds of the outstanding shares, or 0.5 million shares. After the repurchase, the total number of outstanding shares would be 0.25 million, or one-third of the original amount.

The new net income of the firm can be found by subtracting the interest expense ($200,000) from the operating income ($1.5 million), which is $1.3 million. Since the total number of shares has been reduced, the EPS would increase to $1.3 million / 0.25 million = $5.20. Therefore,D is the correct option.

An All-Equity Firm as Operating Income of $1