Donat Corp. is a small company looking at two possible capital structures. Curre

Question

Donat Corp. is a small company looking at two possible capital structures. Currently, the firm is an all-equity firm with $600,000 in assets and 100,000 shares outstanding. The market value of each share is $6.00. The CEO of Donat is thinking of leveraging the firm by selling $300,000 of debt financing and retiring 50,000 shares, leaving 50,000 shares outstanding. The cost of debt is 5% annually, and the current corporate tax rate for Donat is 30%. The CEO believes that Donat will earn $50,000 per year before interest and taxes. Which of the statements below is TRUE? ______

A) Shareholders will be better off by $0.14 per share under a firm with $300,000 in debt financing versus a firm that is all-equity.

B) 50/50 debt-to-equity EPS is $0.49.

C) All-equity EPS is $0.35.

D) Statements (A) through (C) are all true.

Explanation / Answer

All three are true.

EPS without debt financing 50,000*(1-.3)/100,000= .35

EPS with debt financing 50,000- 300,000*.05= 35,000. 35,000*(1-.3)/50,000= 0.49

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