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9 October, 09:57

Consider a firm with an EBIT of $500,000. The firm finances its assets with $2,000,000 debt (costing 6 percent) and 50,000 shares of stock selling at $20.00 per share. To reduce the firm's risk associated with this financial leverage, the firm is considering reducing its debt by $1,000,000 by selling an additional 50,000 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 $500,000. What is the change in the firm's EPS from this change in capital structure?

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  1. 9 October, 12:22
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    EPS is reduced by $1.92 and 42%

    Explanation:

    EBIT $500,000

    Interest Expense ($120,000) ($2,000,000 x 6%)

    EBT $380,000

    Tax 40% ($152,000)

    Net Earninig $228,000

    Outstanding stock = 50,000

    EPS = $228,000 / 50,000 = $4.56 per share

    Change in Capital Structure.

    EBIT $500,000

    Interest Expense ($60,000) ($1,000,000 x 6%)

    EBT $440,000

    Tax 40% ($176,000)

    Net Earninig $264,000

    Outstanding stock = 50,000 + 50,000 = 100,000

    EPS = $264,000 / 100,000 = $2.64 per share

    Change in EPS = $4.56 - $2.64 = $1.92 per share

    Change in EPS = $1.92 / $4.56 = 0.42 = 42%
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