00 Sprint 88%) 12:34 PM ezto.mheducation.com value: 10.00 points Problem 16-6 Le

Question

00 Sprint 88%) 12:34 PM ezto.mheducation.com value: 10.00 points Problem 16-6 Leverage and Earnings (LO1) Reliable Gearing currently is all-equity-financed. It has 30,000 shares of equity outstanding, selling at $100 a share. The firm is considering a capital restructuring. The low-debt plan calls for a debt issue of $400,000 with the proceeds used to buy back stock. The high-debt plan would exchange $600,000 of debt for equity. The debt will pay an interest rate of 12%. The firm pays no taxes. a. What will be the debt-to-equity ratio if it borrows $400,000? (Do not round intermediate calculations. Round your answer to 2 decimal places.) Debt-to-equity ratio b. If earnings before interest and tax (EBIT) are $310,000, what will be earnings per share (EPS) if Reliable borrows $400,000? (Do not round intermediate calculations. Round your answer to 2 decimal places.) EPS c. What will EPS be if it borrows $600,000? (Do not round intermediate calculations. Round your answer to 2 decimal places.) EPS 9.99 References Worksheet Difficulty: Intermediate Problem 16-6 Leverage and Earnings (LO1) Learning Objective: 16-01 Show why capital structure does not affect firm value in perfect capital markets

Explanation / Answer

Part 1)

The amount of debt will be used to buy back the stock, resulting in a decline in the number of outstanding shares which would further result in decline in the value of equity.

Market Value of Equity = Number of Outstanding Shares*Per Share Price = 30,000*100 = $3,000,000

Value of Equity after Repurchase = 3,000,000 - 400,000 = 2,600,000

_______

Revised Debt to Equity Ratio = Debt/Revised Equity after Repurchase = 400,000/2,600,000 = .15

______

Part B)

The EPS has been calculated with the use of following table:

Notes:

Number of Outstanding Shares = Current Outstanding Shares - Shares Bought Back = 30,000 - 400,000/100 = 26,000 shares

______

Part C)

The EPS has been calculated with the use of following table:

Notes:

Number of Outstanding Shares = Current Outstanding Shares - Shares Bought Back = 30,000 - 600,000/100 = 24,000 shares

Earnings before Interest and Taxes 3,10,000 Less: Interest Expense (400,000*12%) 48,000 Earnings before Taxes 2,62,000 Less: Taxes 0 Earnings after Taxes (A) 2,62,000 Number of Shares (30,000 – 400,000/100) (B) 26,000 Earnings Per Share $10.08

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