ABC Corporation has a capital structure that consists of $20 million in debt and $40 million in equity. The debt has a coupon rate of 10%, while the industry return on equity is 15%. ABC Corporation is unsure of the state of the economy in the next year. The tax rate facing the company is 40%.

-Refer to ABC Corporation.The company is considering the issue of $10 million in new debt at a rate of 10%.The funds from the new debt will be used to retire $10 million in equity.Currently,there are 1 million shares outstanding trading at $40 per share.Assuming the stock price will remain the same,what is the expected earnings per share in the next year if the company goes through with the re-capitalization?

Question

ABC Corporation has a capital structure that consists of $20 million in debt and $40 million in equity. The debt has a coupon rate of 10%, while the industry return on equity is 15%. ABC Corporation is unsure of the state of the economy in the next year. The tax rate facing the company is 40%.
 
-Refer to ABC Corporation.The company is considering the issue of $10 million in new debt at a rate of 10%.The funds from the new debt will be used to retire $10 million in equity.Currently,there are 1 million shares outstanding trading at $40 per share.Assuming the stock price will remain the same,what is the expected earnings per share in the next year if the company goes through with the re-capitalization?

Quizplus · Accepted Answer

Re-capitalize:
Total Debt = $20 + $10 = $30
# of shares = $30 million / $40 per share = 750,000
Interest payment = $30*.10 = $3 million
NI (bad)= ($3-$3)*(1-.4)= $0
NI (good)= ($5-$3)*(1-.4)= $1.2 million
NI (great)= ($10 - $3)*(1-.4)= $4.2 million
Expected EPS = ($0*.4+$1.2*.4+$4.2*.2)/.75 = $1.76

ABC Corporation Has a Capital Structure That Consists of $20