Wealth and Health Company is financed entirely by common stock that is priced to offer a
15% expected return. The common stock price is $40/share. The earnings per share (EPS) is expected to be $6. If the company repurchases 25% of the common stock and substitutes an equal value of debt yielding 6%, what is the expected value of earnings per share after refinancing? (Ignore taxes.)
A) $6.00
B) $7.52
C) $7.20
D) None of the above

Question

Quizplus · Accepted Answer

Before refinancing, the company had 10,000 outstanding shares and an earnings of $6 per share, leading to a total earnings of $60,000.

If the company repurchases 25% of the common stock, it will buy back 2,500 shares and have a remaining 7,500 outstanding shares. The value of the repurchased stock is 2,500 * $40 = $100,000.

The company will then substitute an equal value of debt, which means it will issue $100,000 in debt at a yield of 6%. This will lead to annual interest payments of $6,000.

The remaining 7,500 shares need to generate a total earnings of $66,000 to maintain the original EPS of $6. Therefore, the new EPS will be $66,000 / 7,500 = $8.80.

However, the interest payments of $6,000 need to be subtracted from the total earnings to arrive at the net earnings available to common shareholders. Therefore, the expected value of earnings per share after refinancing is:

($66,000 - $6,000) / 7,500 = $7.20

Therefore, the correct answer is C.

Wealth and Health Company Is Financed Entirely by Common Stock