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 . 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 50% and the number of shares in circulation is cut by 50% (assuming that the share price remains unchanged with this change in capital structure)?

Question

Quizplus · Accepted Answer

With the increase in borrowing and interest expense by 50%, the new interest expense becomes $375,000 ($250,000 * 1.5). Reducing the number of shares by 50% means there are now 50,000 shares. The new operating income remains the same at $1.5 million. Subtracting the new interest expense from the operating income gives $1,125,000 ($1,500,000 - $375,000) as the earnings available to shareholders. Dividing this by the new number of shares (50,000) results in an EPS of $22.50.

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