Question

North Side, Inc. has no debt outstanding and a total market value of $168,000. Earnings before interest and taxes, EBIT, are projected to be $18,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be $21,960 . The company is considering a $50,000 debt issue with an interest rate of 7.4 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,000 shares outstanding and the tax rate is 21 percent. What is the EPS for each capital structure under each scenario? If we ignore taxes, what is the break-even EBIT?

Answer 1

Answer:

The Breakeven EBIT is 12432.

Explanation:

                         NORMAL                  STRONG EXPANSION

EBIT                    18000                                      21960

Interest                    (3700)                                     (3700)[50000*7.4%]

EBT                              14300                                       18260

Taxes                          (3003)[14300*0.21]                   (3834.6)[18260*.21]

Net Income                11297                                 14425.4

Number of shares outstanding 3511.90                  3511.90

EPS                             11297/3511.9                                  14425.4/3511.90

                                 = $ 3.22 per share                           = $ 4.11 per share

Working:

Share price = Total market value /number of shares outstanding

                    = 168000/5000

                    = $ 33.6 per share

Number of shares repurchased from amount received from debt issue = Total debt /current share price per share

= 50000/33.6

= 1488.10

shares after repurchase = 5000 - 1488.10

                                        = 3511.90

b)There are no taxes.

Alternative I ,Earning per share = EBIT /number of shares outstanding    [Before repurchase]

Alternative II ,earning per share = [EBIT- interest ]/Number of shares outstanding after repurchase.

At breakeven Earning per share under both alternative are equal.

EBIT /5000 = [EBIT-3700]/3511.90

3511.90 *EBIT /5000 = EBIT - 3700

0.70238 EBIT = EBIT -3700

EBIT - 0.70238 EBIT = 3700

          0.29762 EBIT = 3700

                         EBIT = 3700/0.29762

                                  = 12431.96  

Therefore, The Breakeven EBIT is 12432.