TCH Corporation is considering two alternative capital structures with the following characteristics.
AB -
Debt/Assets ratio0.30.7 -
kd10%14%
The firm will have total assets of $500,000, a tax rate of 40 percent, and book value per share of $10, regardless of capital structure. EBIT is expected to be
$200,000 for the coming year. What is the difference in earnings per share (EPS) between the two alternatives?
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A. B. C. D. E.B
Capital structure A: The firm will have debt of $500,000(0.3) = $150,000 and equity of $350,000. We're told the shares have a book value of $10 so the number of shares outstanding is $350,000/$10 = 35,000. Interest expense will be $150,000(10%) = $15,000. We can compute EBT as EBIT - I or $200,000 - $15,000 =
$185,000. Also, we can compute NI as EBT(1 - T) or $185,000(1 - 0.4) = $111,000. Finally, EPS = $111,000/35,000 = $3.17. Capital structure B: The firm will have debt of $500,000(0.7) = $350,000 and equity of $150,000. The number of shares outstanding is $150,000/$10 = 15,000. Interest expense will be $350,000
(14%) = $49,000. We can compute EBT as $200,000 - $49,000 = $151,000. Also, we can compute NI as $151,000 (1 - 0.4) = $90,600. Finally, EPS =
$90,600/15,000 = $6.04. The difference in EPS between capital structure A and capital structure B is $6.04 - $3.17 = $2.87.