What happens to an all-equity firm's EPS when $1 million of 20% debt is issued and proceeds used to repurchase two-thirds of the stock if operating income equals $1.5 million and EPS were $2 when the firm was all-equity-financed? Ignore taxes.

Question

Quizplus · Accepted Answer

Before issuing debt and repurchasing stock:
- Operating income = $1.5 million
- EPS = $2.00

After issuing debt and repurchasing stock:
- Operating income stays the same at $1.5 million
- Debt amount = $1 million, with a 20% interest rate, will lead to $200,000 in interest payments
- Net income available to equity holders will now be $1.3 million ($1.5 million - $200,000 interest)
- Total shares outstanding reduced by two-thirds, so total shares outstanding is now one-third of the original amount
- EPS now is $5.20 ($1.3 million / (1/3 of original shares))

What Happens to an All-Equity Firm's EPS When $1 Million