Copybold Corporation is a start-up company that has a capital structure with a debt/assets ratio equal to 0.75. Copybold has no preferred stock. There are two possible scenarios with respect to the firm's operations: Feast or Famine. The Feast scenario has a 60 percent probability of occurring, and the forecast earnings before interest and taxes (EBIT) in this scenario is $60,000. The Famine scenario has a 40 percent chance of occurring, and the EBIT is expected to be $20,000. Further, the firm's cost of debt is 12 percent. The firm has $400,000 in total assets, and its marginal tax rate is 40 percent. The company has 10,000 shares of stock outstanding. What is the difference between the earnings per share (EPS) forecasts for the Feast scenario and the Famine scenario?
A)$1.44 per share
B)$2.40 per share
C)$1.48 per share
D)$0.48 per share
E)$0.96 per share

Question

Quizplus · Accepted Answer

First, we need to calculate the firm's net income in each scenario:
- Feast scenario: EBIT = $60,000, interest expense = $400,000 x 0.75 x 12% = $36,000, taxable income = $24,000, net income = $14,400 (after 40% tax rate)
- Famine scenario: EBIT = $20,000, interest expense = $400,000 x 0.75 x 12% = $36,000, taxable loss = ($16,000), net income = $0 (after 40% tax rate)
Next, we can calculate the earnings per share (EPS) in each scenario:
- Feast scenario: EPS = ($14,400 - 0) / 10,000 = $1.44/share
- Famine scenario: EPS = ($0 - 0) / 10,000 = $0/share
The difference between EPS forecasts for Feast and Famine scenarios is $1.44/share - $0/share = $1.44/share.
Therefore, the best choice is B.

Copybold Corporation Is a Start-Up Company That Has a Capital