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Q: Leverage and Equity ( Answered 4 out of 5 stars,   1 Comment )
Subject: Leverage and Equity
Category: Business and Money > Finance
Asked by: carrollton22-ga
List Price: $5.00
Posted: 15 Jun 2006 12:06 PDT
Expires: 15 Jul 2006 12:06 PDT
Question ID: 738465
I am trying to figure out how to tackle a finance problem. I don't
want anyone to give me the answer as I need to understand how to do
it. Feel free to make up your own example to explain the problem.

A company has a set amount of shares selling at a specific dollar
amount. It wants to take issue debt to buy back stock. The debt pays
an interest rate of X. From this information, I can get the
Debt-to-equity ratio. If EBIT is Y, how do I figure out the EPS? -
Subject: Re: Leverage and Equity
Answered By: livioflores-ga on 15 Jun 2006 19:54 PDT
Rated:4 out of 5 stars
Hi again!!

"EPS" refers to earnings per share. It is calculated after deducting
interest and taxes payable from the operating profit (EBIT), as also
dividend, if any, on preference shares. The residual amount represents
the earning available to common shareholders. If this amount is
divided by the number of shares of equity outstanding, you will find
the EPS. So the formula to take into account is:
EPS = (EBIT - I)*(1-T)/ S

EBIT = earnings before interest and taxes
I = interest expenses or interest obligations
T = marginal tax rate 
S = number of shares of common stock

You know the following:
Debt = the debt issued by the company to buy back the shares = D
Debt interest rate = X
From X and D you can figure I = X*D
If taxes are not specified then you cn consider a "without taxes"
case, that is T = 0 .
Ps = price per share
So = the initial amount of shares
Sp = the amount of shares bought back = D/Ps
From So and Sp you can figure S = So - Sp , the amount of remaining
shares where the earning available to common shareholders will be
Note that if you know the debt equity ratio (D/E) and D, then:
Equity = D/Debt-Equity-Ratio ==> S = [D/Debt-Equity-Ratio]/Ps

Now do the calculation:
EPS = (Y - X*D)*(1-T) / (So - D/Ps) = 
    = (Y - X*D)*(1-T) / (Debt-Equity-Ratio/D)

QWERTY is is an all-equity firm with 50,000 shares outstanding. The
company?s stock price is currently $10 per share. The company?s EBIT
is $2,000,000 , and EBIT is expected to remain constant over time. The
firm?s tax rate is 40 percent.
The company is considering issuing $100,000 of debt and using the
proceeds for a stock repurchase. If issued, the debt would have an
interest rate of 10%.

a) Calculate EPS before the change in capital structure. 

EBIT = $2,000,000
I = $0
T = 0.3

EPS = ($2,000,000 - 0) * (1 - 0.4) / 50,000 = 
    = $1,200,000 / 50,000 =
    = $24

b) Find EPS after the change in capital structure. 

EBIT = $2,000,000
I = X*D = 0.10 * $100,000 = $10,000
T = 0.3
S = So - D/Ps = 50,000 - $100,000/$10 = 40,000

EPS = ($2,000,000 - $10,000)*(1 - 0.4) / 40,000 =
    = $1,194,000 / 40,000
    = $29.85

Note that D = $100,000 and initial equity is $500,000, then after the
change in capital structure D/E = $100,000/$400,000 = 0.25 , then:
EPS = ($2,000,000 - $10,000)*(1 - 0.4) / ([D/Debt-Equity-Ratio]/Ps) =
    = $1,194,000 / [($100,000/0.25)/$10] =
    = $1,194,000 / 40,000 0
    = $29.85 

I hope this helps you. Feel free to request for a clarification if you need it.

carrollton22-ga rated this answer:4 out of 5 stars
Thank you!

Subject: Re: Leverage and Equity
From: omnivorous-ga on 15 Jun 2006 17:50 PDT
Carollton22 --

The basic principal that you want to pay attention to is the
Modigliani-Miller theorem.  Understanding it, you have all of the
information that you need to solve your problem:

Best regards,


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