Income Statement 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

To find the change in EPS, we need to calculate the current EPS and the new EPS assuming the change in capital structure.

Current EPS = (EBIT - Interest)*(1 - tax rate) / Number of shares

where Interest = Debt * Interest rate = $20,000,000 * 5% = $1,000,000

Number of shares = 70,000

Current EPS = (5,000,000 - 1,000,000)*(1 - 0.4) / 70,000 = $42.86

New EPS = (EBIT - Interest)*(1 - tax rate) / (Number of shares + New shares issued)

where New shares issued = 100,000

If the firm reduces its debt by $5,000,000, the new interest expense would be $15,000,000 ($20,000,000 - $5,000,000) at the same interest rate of 5%.

New EPS = (5,000,000 - 15,000,000)*(1 - 0.4) / (70,000 + 100,000) = $23.57

Therefore, the change in EPS would be:

Change in EPS = New EPS - Current EPS = $23.57 - $42.86 = -$19.29

This means that the EPS would decrease by $19.29 per share if the firm sells an additional 100,000 shares to reduce its debt by $5,000,000, and the correct answer is C.

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