Martha White's Fabrics is currently an all equity firm that has 15,000 shares of stock outstanding at a market price of $12.50 a share. Company management has decided to issue $50,000 worth of debt and use the funds to repurchase shares of the outstanding stock. The interest rate on the debt will be 9%. What are the earnings per share at the break-even level of earnings before interest and taxes? Ignore taxes.
A) $1.005
B) $1.125
C) $1.175
D) $1.200
E) $1.250

Question

Quizplus · Accepted Answer

To find the break-even level of earnings before interest and taxes (EBIT), we first calculate the number of shares repurchased with the $50,000 debt. The repurchase price per share is $12.50, so the number of shares repurchased is $50,000 / $12.50 = 4,000 shares. After the repurchase, the company will have 15,000 - 4,000 = 11,000 shares outstanding.The interest expense from the debt is 9% of $50,000 = $4,500.At the break-even level of EBIT, the earnings available to shareholders (after paying interest on the debt) when divided by the number of shares outstanding should give us the earnings per share (EPS).Let EBIT = X. At break-even, EBIT - Interest = Earnings available to shareholders.So, X - $4,500 = Earnings available to shareholders.To find the break-even EPS, we divide the earnings available to shareholders by the number of shares outstanding after the repurchase.Break-even EPS = (X - $4,500) / 11,000.For the EPS to be break-even with the initial scenario (without debt), the EPS should be equal to the initial EPS before the repurchase. Initially, there are no interest expenses, and all earnings are available to shareholders. The initial EPS is not directly given, but we can deduce the break-even condition without calculating it explicitly.Given the choices provided, we need to find the EBIT that results in one of these EPS values after paying the $4,500 interest and dividing by the 11,000 shares.Since we're ignoring taxes and looking for the EPS at the break-even level of EBIT, we can set up the equation based on the interest expense and the new number of shares:EBIT - Interest Expense = Earnings available to shareholders.We know the interest expense is $4,500, and we are looking for the EBIT that, after paying this interest, when divided by the 11,000 shares, gives one of the EPS values listed.Given the absence of explicit EBIT and the instruction to ignore taxes, we focus on the conceptual understanding that the break-even EPS reflects the point where the cost of the debt (interest) is exactly offset by the reduction in the number of shares outstanding.The correct answer, without explicit calculation from the initial conditions (since we're not given the initial EBIT or earnings), relies on understanding the impact of leverage. The question essentially tests the understanding of how debt affects EPS through interest expenses and share repurchase. Given the information provided and the need to select the best answer without further calculations, B) $1.125 is chosen based on the conceptual approach to the problem, assuming a break-even point where the EPS remains constant before and after the issuance of debt and repurchase of shares. However, without explicit initial earnings or EBIT, the calculation directly leading to $1.125 cannot be shown, indicating a focus on the conceptual understanding of financial leverage's impact on EPS.

Martha White's Fabrics Is Currently an All Equity Firm That