Use the following information to answer the question(s)below.
Nielson Motors is currently an all-equity financed firm.It expects to generate EBIT of $20 million over the next year.Currently Nielson has 8 million shares outstanding and its stock is trading at $20.00 per share.Nielson is considering changing its capital structure by borrowing $50 million at an interest rate of 8% and using the proceeds to repurchase shares.Assume perfect capital markets.
-Nielson's EPS if they choose not to change their capital structure is closest to:
A)$2.00.
B)$2.30.
C)$2.50.
D)$2.90.

Question

Quizplus · Accepted Answer

If Nielson Motors does not change its capital structure, it will remain an all-equity financed firm. Therefore, all of the EBIT will belong to the shareholders. The Earnings per share (EPS) can be calculated as:
EPS = EBIT / Number of shares outstanding
EPS = $20 million / 8 million
EPS = $2.50

If Nielson Motors borrows $50 million at an interest rate of 8% and uses the proceeds to repurchase shares, its new capital structure will be 38.46% debt and 61.54% equity.
The interest expense on the debt will be:
Interest expense = 8% of $50 million
Interest expense = $4 million
The net income will then be:
Net income = EBIT - Interest expense
Net income = $20 million - $4 million
Net income = $16 million
The number of shares outstanding after the share repurchase will be:
Number of shares outstanding = 8 million - ($50 million / $20.00 per share)
Number of shares outstanding = 5 million
The EPS will then be:
EPS = Net income / Number of shares outstanding
EPS = $16 million / 5 million
EPS = $3.20

Therefore, if Nielson Motors chooses to change its capital structure by borrowing $50 million at an interest rate of 8% and using the proceeds to repurchase shares, the EPS will increase to $3.20. This is a better choice as it will increase shareholder value.

Use the Following Information to Answer the Question(s)below