Fresh out of Harvard Business School, Joe Walker, the new CFO of Joe\'s Southern

Question

Fresh out of Harvard Business School, Joe Walker, the new CFO of Joe's Southern Cornbread Company, wants to shake things up at the sleepy little food company headquartered in Birmingham, Alabama. The firm is currently an all-equity firm because "that's the way we've always done it." Under pressure from a new group of major stockholders, however, Walker is considering acquiring some debt (leverage) in an effort to boost earnings per share. The company currently has 600 shares, but he is thinking about borrowing $6,000 at 10% per year and buying back 200 of those shares. Refer to the scenario above. What level of EBIT would make this an attractive strategy? Please help me solve.

Explanation / Answer

Let the value of EBIT be "X"

After taking Interest expense, the profit would be:

Interest expense = $6,000 X 10% = $600

Profit after interest = X - $600

EPS= Net income / Number of shares outstanding

Old EPS = (X ) / 600

New EPS = (X - $600) / 800

Hence, the EBIT would be:

(X ) / 600 = (X - $600) / 800

800(X) = 600 (X) - $360,000

200 (X) = $360,000

          X = $1,800

Therefore, the level of EBIT is $1800

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