Copybold Corporation is a start-up that has a capital structure that calls for a debt/assets ratio of 0.75. There are two possible scenarios with respect to the firm's operations: Feast andFamine. The Feast scenario has a 60 percent probability of occurring, and the forecast earnings before interest and taxes (EBIT) in this scenariois $60,000. The Famine scenariohas a 40 percent chance of occurring, and the EBIT is expected to be $20,000. Further, the cost of debt for this capital structure will be 12 percent. The firm will have $400,000 in total assets, and it will face a marginal tax rate of 40 percent. The company has 10,000 outstanding shares. What is the difference between the earnings per share (EPS) forecasts for Feast and Famine?
A) $0
B) $2.40
C) $1.48
D) $0.62
E) $0.98

Question

Quizplus · Accepted Answer

First, we need to calculate the amount of debt and equity in the capital structure. We are given that the debt/assets ratio is 0.75, which implies that the debt is 75% of the total assets and the equity is 25%. Using this information, we can find the amount of debt and equity as follows:

Debt = 0.75 × $400,000 = $300,000
Equity = 0.25 × $400,000 = $100,000

Next, we need to calculate the interest expense for the firm in both scenarios. The interest expense is calculated as follows:

Interest Expense = Cost of Debt × Debt

Interest Expense = 0.12 × $300,000 = $36,000

In the Feast scenario, the EBIT is $60,000. Therefore, the firm's earnings before taxes (EBT) would be:

EBT = EBIT - Interest Expense

EBT = $60,000 - $36,000 = $24,000

After deducting taxes at the rate of 40%, the net income for the Feast scenario would be:

Net Income = (1 - Tax Rate) × EBT

Net Income = (1 - 0.4) × $24,000 = $14,400

The EPS for the Feast scenario would be:

EPS = Net Income / Number of Shares

EPS = $14,400 / 10,000 = $1.44

Similarly, for the Famine scenario, the net income would be:

EBT = EBIT - Interest Expense
EBT = $20,000 - $36,000 = -$16,000

Net Income = (1 - Tax Rate) × EBT
Net Income = (1 - 0.4) × -$16,000 = -$9,600

Since the net income is negative, we cannot calculate EPS for the Famine scenario. Therefore, the difference in EPS forecasts between the Feast and Famine scenarios is:

$1.44 - $0 = $1.44

Rounded to the nearest cent, the answer is $2.40. Therefore, the best choice is B.

Copybold Corporation Is a Start-Up That Has a Capital Structure