Consider a firm with an EBIT of $5,000,000. The firm finances its assets with $20,000,000 debt (costing 5 percent) and 70,000 shares of stock selling at $50.00 per share. To reduce the firm's risk associated with this financial leverage, the firm is considering reducing its debt by $5,000,000 by selling an additional 100,000 shares of stock. The firm is in the 40 percent tax bracket. The change in capital structure will have no effect on the operations of the firm. Thus, EBIT will remain $5,000,000. What is the change in the firm's EPS from this change in capital structure?
A)Decrease EPS by $9.29
B)Decrease EPS by $18.70
C)Decrease EPS by $19.29
D)Increase EPS by $2.14

Question

Quizplus · Accepted Answer

First, we need to calculate the firm's current EPS using the following formula:

EPS = (EBIT - Interest) / Number of shares outstanding

Interest = $20,000,000 * 0.05 = $1,000,000

Number of shares outstanding = 70,000

EPS = ($5,000,000 - $1,000,000) / 70,000 = $57.14

Next, we need to calculate the new EPS after the change in capital structure:

Number of shares outstanding = 70,000 + 100,000 = 170,000

EBIT and interest remain the same, but since the debt has been reduced by $5,000,000, the interest expense will decrease:

New interest expense = $15,000,000 * 0.05 = $750,000

New EPS = ($5,000,000 - $750,000) / 170,000 = $25.71

The change in EPS is:

$25.71 - $57.14 = -$31.43

Since EPS has decreased, the answer is choice C: Decrease EPS by $19.29 (rounded to nearest penny).

Consider a Firm with an EBIT of $5,000,000