Learn and Earn Company is financed entirely by common stock that is priced to offer a 20 percent expected rate of return. The stock price is $60 and the earnings per share are $12. If the company repurchases 50 percent of the stock and substitutes an equal value of debt yielding 8 percent, what is the expected earnings per share value after refinancing?
A)$12.00
B)$19.20
C)$24.00
D)$15.60

Question

Quizplus · Accepted Answer

The correct answer is B. The expected earnings per share value after refinancing is $19.20.The company's current earnings per share is $12. If the company repurchases 50 percent of the stock, the number of shares outstanding will be reduced by 50 percent. This will increase the earnings per share by 50 percent, to $18.The company is also substituting an equal value of debt yielding 8 percent. This will reduce the company's interest expense, which will increase the earnings per share. The amount of interest expense that will be saved is equal to the amount of debt that is issued, multiplied by the interest rate. In this case, the amount of debt that is issued is $30 (50 percent of the stock price), and the interest rate is 8 percent. Therefore, the amount of interest expense that will be saved is $2.40.The total increase in earnings per share is $18 + $2.40 = $20.40. However, the number of shares outstanding has been reduced by 50 percent, so the expected earnings per share value after refinancing is $20.40 / 2 = $19.20.

Learn and Earn Company Is Financed Entirely by Common Stock