Question

Reliable Gearing currently is all-equity-financed. It has 10,000 shares of equity outstanding, selling at $100 a share. The firm is considering a capital restructuring. The low-debt plan calls for a debt issue of $200,000 with the proceeds used to buy back stock. The high-debt plan would exchange $400,000 of debt for equity. The debt will pay an interest rate of 10%. The firm pays no taxes.
a. What will be the debt-to-equity ratio if it borrows $200,000?
b. If earnings before interest and tax (EBIT) are $110,000, what will be earnings per share (EPS) if Reliable borrows $200,000?
c. What will EPS be if it borrows $400,000?

Answer 1

Answer:

Part a. What will be the debt-to-equity ratio if it borrows $200,000?

25%

Part b. If earnings before interest and tax (EBIT) are $110,000, what will be earnings per share (EPS) if Reliable borrows $200,000?

$11.25 or 1125 cents

Part c. What will EPS be if it borrows $400,000?

$11.67 or 1167 cents

Explanation:

Part a. What will be the debt-to-equity ratio if it borrows $200,000?

If it Borrows $200,000 then, debt will Increase by $200,000 and Shares will decrease by $200,000 since they would be bought back under this option

Debt-to-equity ratio measures the extent to which Foreign Money is used by the Company

Debt-to-equity ratio = Total Debt / Total Equity

                                = $200,000/ $1,000,000 - $ 200,000

                                = $200,000/$800,000

                                = 25%

Part b. If earnings before interest and tax (EBIT) are $110,000, what will be earnings per share (EPS) if Reliable borrows $200,000?

Earnings per share (EPS) = Earnings Attributable to Ordinary Shareholders/ Weighted Average Number of Ordinary Shares in Issue during the period

                                         =( $110,000 - $200,000×10%)/ ($800,000/$100)

                                         = $110,000-$20,000/8,000

                                         = $11.25 or 1125 cents

Part c. What will EPS be if it borrows $400,000?

If it borrows $400,000 then, it pursues the High -Debt Plan and exchanges debt for equity

Earnings per share (EPS) = Earnings Attributable to Ordinary Shareholders/ Weighted Average Number of Ordinary Shares in Issue during the period

                                          = ( $110,000 - $400,000×10%)/ ($1,000,000-$400,000/$100)

                                          = $70,000 / 6,000

                                          = $11.67 or 1167 cents