Firewall Corp.is a small company looking at two possible capital structures.Currently,the firm is an all-equity firm with $900,000 in assets and 100,000 shares outstanding.The market value of each share is $9.00.The CEO of Firewall is thinking of leveraging the firm by selling $270,000 of debt financing and retiring 30,000 shares,leaving 70,000 shares outstanding.The cost of debt is 6% annually,and the current corporate tax rate for Firewall is 30%.The CEO believes that Firewall will earn $100,000 per year before interest and taxes.Which of the statements below is TRUE?
A)All-equity EPS is $0.70.
B)30/70 debt-to-equity EPS is $0.838.
C)Shareholders will be better off by almost $0.14 per share under a firm with $270,000 in debt financing versus a firm that is all-equity.
D)Statements A,B,and C are all true.

Question

Quizplus · Accepted Answer

A) All-equity EPS = ($100,000/100,000 shares) = $1 per share; EPS assuming no debt financing.
B) 30/70 debt-to-equity EPS = [($100,000 - $16,200)/70,000 shares] = $1.146 per share; EPS including debt-financing.
C) Change in EPS = $1.146 - $0.70 = $0.446 or $0.45 per share. This means that shareholders will be better off by $0.45 per share under a firm with $270,000 in debt financing versus a firm that is all-equity because the EPS will increase.
Therefore, options A, B, and C are all true.