Question

Your company faces a 40% tax rate and has $265 million in assets, currently financed entirely with equity. Equity is worth $9.50 per share, and book value of equity is equal to market value of equity. Also, let's assume that the firm's expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities as shown below:

State	Pessimistic	Optimistic
Probability of State	.35	.65
Expect EBIT in State	$11.5 million	$51.5 million

The firm is considering switching to a 30-percent debt capital structure, and has determined that they would have to pay a 8 percent yield on perpetual debt in either event. What will be the level of expected EPS if they switch to the proposed capital structure? (Round your intermediate calculations and final answer to 2 decimal places, except calculation of number of shares which should be rounded to nearest whole number.)

Multiple Choice

• $.96

• $.77

• $1.39

• $1.54

Answer 1

IF ANY QUERY, FEEL FREE TO ASK Solution 1 Change in Capital Structure Equity Debt = = Assets x (1 - Debt%) Assets x Debt% = = 265000000 x (1 - 30%) = 265000000 x 30% = 185500000 79500000 2 Number of Equity Shares Number of Equity Shares Asset / Equity worth per share 185500000/9.5 = 19526316 = 3 Expected EBIT Expected EBIT = = Sum of EBIT x Probability 11500000 x 0.35 + 51500000 x 0.65 4025000 + 33475000 37500000 4 Earning per Share (EPS) EPS (Expected EBIT - Interest) x (1 - Tax rate) Number of equity shares (37500000 - 79500000 x 8%) x (1 - 40%) 19526316 18684000 = 0.96 19526316 Hence, 1st option $0.96 is correct.

Answer 2

Option number one is right.