A firm issues 100,000 equity shares with a total market value of $5,000,000.The firm's market value of debt is also of equal amount, i.e., $5,000,000.The firm is expected to generate $1.5 million in operating income and pay $250,000 in interest.Ignoring taxes, this will generate $12.50 earnings per share.What will happen to EPS if the firm's borrowing and interest expense increases by 50% and the number of shares in circulation is cut by 50% (assuming that the share price remains unchanged with this change in capital structure)?(Use values in dollar.)

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Quizplus · Accepted Answer

With the increase in borrowing and interest expense by 50%, the new interest expense becomes $375,000 ($250,000 * 1.5). The operating income remains the same at $1.5 million. Therefore, the new net income is $1,125,000 ($1,500,000 - $375,000). With the number of shares cut by 50%, the new number of shares is 50,000 (100,000 * 0.5). The new EPS is $22.50 ($1,125,000 / 50,000).

A Firm Issues 100,000 Equity Shares with a Total Market