Your company has a 38% tax rate and has $800 million in assets, currently financed entirely with equity. Equity is worth $60 per share, and book value of equity is equal to market value of equity. Also, let's assume that the firm's expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities as shown below: The firm is considering switching to a 20-percent debt capital structure, and has determined that they would have to pay a 10 percent yield on perpetual debt in either event. What will be the level of expected EPS if they switch to the proposed capital structure?

Question

Your company has a 38% tax rate and has $800 million in assets, currently financed entirely with equity. Equity is worth $60 per share, and book value of equity is equal to market value of equity. Also, let's assume that the firm's expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities as shown below:  The firm is considering switching to a 20-percent debt capital structure, and has determined that they would have to pay a 10 percent yield on perpetual debt in either event. What will be the level of expected EPS if they switch to the proposed capital structure?

Quizplus · Accepted Answer

To calculate the level of expected EPS, we need to follow these steps:

1. Calculate the current EBIT and EPS:

The expected EBIT in the current capital structure can be calculated as follows:

EBIT = (0.1 x 200) + (0.15 x 300) + (0.25 x 400) + (0.35 x 500) = $357.5 million

Thus, the current EPS can be calculated as follows:

EPS = (EBIT - Interest) x (1 - Tax Rate) / Number of shares

As the firm is currently financed entirely with equity, the interest is zero, and the EPS is simply:

EPS = EBIT x (1 - Tax Rate) / Number of shares = $2.36

2. Calculate the expected EBIT and EPS in the proposed capital structure:

To calculate the expected EBIT in the proposed capital structure, we need to find the new interest expense and subtract it from the EBIT calculated above. The interest expense can be calculated as follows:

Interest Expense = 0.2 x $800 million x 0.10 = $16 million

Thus, the expected EBIT in the proposed capital structure can be calculated as follows:

EBIT = (0.1 x 200 - $16) + (0.15 x 300 - $16) + (0.25 x 400 - $16) + (0.35 x 500 - $16) = $333.5 million

Now, we can calculate the EPS in the proposed capital structure as follows:

EPS = (EBIT - Interest) x (1 - Tax Rate) / Number of shares

EPS = ($333.5 - $16) x (1 - 0.38) / (800 / 60) = $2.44

Therefore, the expected EPS in the proposed capital structure is $2.44, which is higher than the current EPS of $2.36. The best choice is D.

Your Company Has a 38% Tax Rate and Has $800