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 75% and the number of shares in circulation is cut by 75% (assuming that the share price remains unchanged with this change in capital structure)?

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The initial interest expense is $250,000. Increasing this by 75% gives a new interest expense of $437,500 ($250,000 * 1.75). The initial number of shares is 100,000, and reducing this by 75% leaves 25,000 shares. The new operating income remains the same at $1.5 million. Subtracting the new interest expense from the operating income gives $1,062,500 ($1,500,000 - $437,500). Dividing this by the new number of shares (25,000) gives an EPS of $42.50 ($1,062,500 / 25,000).

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