Learn and Earn Company is financed entirely by common stock that is priced to offer a
20% expected rate of return. The stock price is $60 and the earnings per share are $12. If the company repurchases 50% of the stock and substitutes an equal value of debt yielding 8%, what is the expected earnings per share value after refinancing?
A) $12.00
B) $19.20
C) $24.00
D) None of the above

Question

Quizplus · Accepted Answer

First, we need to find out the current earnings yield of the stock:

Earnings Yield = Earnings per share / Stock Price
Earnings Yield = $12 / $60
Earnings Yield = 0.2 or 20%

This current earnings yield is the same as the expected rate of return for the stockholders.

Then, we need to find out the earnings per share after the refinancing:

First, we need to find out the new price per share after the stock buyback:

New Price Per Share = Current Price Per Share / (1 - Buyback Percentage)
New Price Per Share = $60 / (1 - 50%)
New Price Per Share = $120

Next, we need to find out the new earnings per share after the substitution of debt:

New Earnings Per Share = Current Earnings Per Share * (1 - Interest Rate) + (Interest Rate * Amount of Debt) / New Number of Shares
New Earnings Per Share = $12 * (1 - 0.08) + (0.08 * ($60 * 0.5)) / (0.5 * $120)
New Earnings Per Share = $10.56

Therefore, the expected earnings per share value after refinancing is $10.56, which is 12% lower than the current earnings per share. Choice B is the best answer.

Learn and Earn Company Is Financed Entirely by Common Stock