Fresh out of Harvard Business School, John Thompson, the new CFO of Joe's Southern Cornbread Company, wants to shake things up at the sleepy little food company headquartered in Birmingham, Alabama. The firm is currently an all-equity firm because "that's the way we've always done it." Under pressure from a new group of major stockholders, however, Walker is considering acquiring some debt (leverage) in an effort to boost earnings per share. The company currently has 8000 shares of common stock outstanding, but he is thinking about borrowing $16,000 at 8% per year and buying back 2000 of those shares. John Thompson is currently living in a world with no taxes.
-Refer to the scenario above.What level of EBIT would make this an attractive strategy?

Question

Quizplus · Accepted Answer

To determine the level of EBIT that would make this an attractive strategy, we need to calculate the earnings per share (EPS) under the current all-equity structure and under the proposed leverage structure.

Under the all-equity structure, EPS is simply net income divided by the number of shares outstanding:

EPS = Net Income / Number of Shares Outstanding

Under the proposed leverage structure, EPS is calculated as follows:

EPS = (Net Income - Interest Expense) / (Number of Shares Outstanding - Shares Repurchased)

We can set these two EPS equations equal to each other and solve for EBIT:

Net Income / 8000 = (Net Income - 0.08 * $16,000) / 6000

Simplifying this equation gives:

Net Income = $5,120

So, the level of EBIT that would make this an attractive strategy is $5,120. Any EBIT above this level would result in higher EPS under the leverage structure compared to the all-equity structure.

Fresh Out of Harvard Business School, John Thompson, the New