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Q: Leverage and Equity ( Answered ,   1 Comment )
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 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? - thanks!```
 ```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 where: 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: EBIT = Y 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 divided. 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) Example: 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. Regards, livioflores-ga```
 carrollton22-ga rated this answer: `Thank you!`
 ```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: http://answers.google.com/answers/threadview?id=566672 Best regards, Omnivorous-GA```