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 75% and the number of shares in circulation is cut by 75% (assuming that the share price remains unchanged with this change in capital structure)?

Question

Quizplus · Accepted Answer

The increase in borrowing and interest expense by 75% leads to higher interest payments, reducing net income. However, reducing the number of shares by 75% significantly decreases the share count, leading to a higher EPS despite the lower net income. This is because the reduction in shares has a more substantial effect on EPS calculation than the increase in interest expense.

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