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 would the unleveraged and leveraged EPSs look like if EBIT were only $4,000?

Question

Quizplus · Accepted Answer

To calculate the unleveraged EPS, we can use the basic EPS formula:
EPS = (EBIT - Taxes) / Shares outstanding

Since there are no taxes in this scenario, the unleveraged EPS would be:
EPS = EBIT / Shares outstanding = $4,000 / 8,000 = $0.50

To calculate the leveraged EPS, we need to adjust the EPS formula to reflect the interest expense on the borrowed funds:
EPS = (EBIT - Interest - Taxes) / Shares outstanding

Assuming no taxes (as stated in the scenario), the leveraged EPS would be:
EPS = (EBIT - Interest) / Shares outstanding
EPS = ($4,000 - $1,280) / 6,000 = $0.453

Therefore, the unleveraged EPS is higher than the leveraged EPS, so acquiring debt would not boost the earnings per share in this scenario.

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