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 breakeven level of earnings before interest and taxes (EBIT), we need to use the following formula:

EBIT = (interest expense) / (1 - tax rate)

Since we are ignoring taxes in this problem, we can simplify the formula to:

EBIT = interest expense

The interest expense can be calculated as follows:

Interest expense = $50,000 x 9% = $4,500

Next, we need to calculate the new number of shares outstanding after the share repurchase. Since the repurchase amount is $50,000 and the market price of the stock is $12.50 per share, we can calculate the number of shares that will be repurchased as follows:

Number of shares repurchased = $50,000 / $12.50 = 4,000

The new number of shares outstanding will be:

New number of shares outstanding = 15,000 - 4,000 = 11,000

Finally, we can calculate the earnings per share (EPS) at the breakeven level of EBIT as follows:

EPS = (EBIT - interest expense) / number of shares outstanding
EPS = ($0 - $4,500) / 11,000
EPS = -$0.41

This means that the company would need to have an EBIT of $4,500 just to break even (i.e., have an EPS of $0). Any EBIT above $4,500 would result in a positive EPS.

Therefore, the closest answer choice is B) $1.125.

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