2. Cross City Tunnel (CCT) Ltd currently has 5 million shares on issue each with

Question

2. Cross City Tunnel (CCT) Ltd currently has 5 million shares on issue each with a market price of $2.50. CCT also has $3 million of debt. The Chief Financial Offer is considering changing the capital structure by issuing $4 million of debt and using the entire proceeds to conduct a share buyback. The interest rate on debt is 10% pa. and the company tax rate is 30%. (a) Calculate EPS for both the current and the proposed capital structures at a projected EBIT level of $3.7 million. Which capital structure is preferable if this is the expected level of EBIT? (b) At what level of EBIT is CCT indifferent between the two capital structures under consideration? (c) Graph the current and proposed capital structures.

Explanation / Answer

(a)

EPS under current capital structure =

EPS under proposed capital structure

Considering the EPS, Proposed capital structure is preferable as it has higher EPS

(b)

At EBIT level of $ 3015000 (Rounded off), CCT is indifferent between the two capital structures, the relevant calculation is as follows:

(c)

EBIT 3700000 Interest 300000 EBT 3400000 Tax 1020000 EAT 2380000 No. of Shares 5000000 EPS 0.476

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