Your girlfriend plans to start a new company to make a new type of cat litter. H
ID: 2613012 • Letter: Y
Question
Your girlfriend plans to start a new company to make a new type of cat litter. Her father will finance the operation, but she will have to pay him back. You are helping her, and the issue now is how to finance the company, with equity only or with a mix of debt and equity. The price per unit will be $10.00 regardless of how the firm is financed. The expected fixed and variable operating costs, along with other information, are shown below. How much higher or lower will the firm's expected EPS be if it uses some debt rather than only equity, i.e., what is EPS - EPS? 0% Debt, U 60% Debt, L Expected unit sales 240,000 240,000 Price per unit $10.00 $10.00 Fixed costs $1,000,000 $1,000,000 Variable cost/unit $3.50 $3.50 Required investment $2,500,000 $2,500,000 Shares issued at $10/share 250,000 100,000 % Debt 0.00% 60.00% Debt, $ $0 $1,500,000 Equity, $ $2,500,000 $1,000,000 Interest rate NA 10.00% Tax rate 35.00% 35.00% Answer $1.04 $1.21 $1.15 $0.93 $1.10
Explanation / Answer
In Case of 0% Debt
Net Income attributable to Equity =(Expected unit sales* (Price per unit - Variable cost/unit ) - Fixed costs)*(1-tax rate)
Net Income attributable to Equity = (240000*(10-3.5)-1000000)*(1-35%)
Net Income attributable to Equity = 364000
EPS = Net Income attributable to Equity/No of Share
EPS = 364000/250000
EPS = 1.456
In Case of 60% Debt
Net Income attributable to Equity =(Expected unit sales* (Price per unit - Variable cost/unit ) - Fixed costs- Interest Expenses)*(1-tax rate)
Net Income attributable to Equity = (240000*(10-3.5)-1000000-1500000*10%)*(1-35%)
Net Income attributable to Equity = 266500
EPS = Net Income attributable to Equity/No of Share
EPS = 266500/100000
EPS = 2.665
Higher will the firm's expected EPS be if it uses some debt rather than only equity = 2.665 - 1.456
Higher will the firm's expected EPS be if it uses some debt rather than only equity = 1.209
Higher will the firm's expected EPS be if it uses some debt rather than only equity = 1.21
Answer
$1.21
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