Assume an initial scenario where a levered firm has total assets of $8,000,earnings before interest and taxes of $600,400 shares of stock outstanding,a debt-equity ratio of .25,and a cost of debt of 7 percent.Now assume a second scenario where the firm changes to an all-equity structure by issuing new shares to pay off debt while a shareholder holding 10 percent of the stock borrows funds at 7 percent and uses homemade leverage to offset the firm's change in capital structure.Ignore taxes.What are the net earnings for this shareholder under the initial scenario? Under the second scenario?
A)$90.00; $90.00
B)$90.00; $112.50
C)$48.80; $38.80
D)$48.80; $48.80
E)$45.00; $48.80

Question

Quizplus · Accepted Answer

Under the initial scenario, the net earnings for the shareholder can be found by multiplying the earnings before interest and taxes by the shareholder's ownership percentage, and then subtracting the interest expense on the debt:

Net earnings = (EBIT x ownership percentage) - (debt x cost of debt)
Net earnings = ($600 x 0.1) - ($8,000 x 0.25 x 0.07)
Net earnings = $48.80

Under the second scenario, the firm has no debt and the shareholder has borrowed funds at the same cost of debt to maintain the same level of leverage. The net earnings for the shareholder can be calculated as follows:

Net earnings = (EBIT - interest expense on homemade leverage) x ownership percentage
Net earnings = ($600 - ($8,000 x 0.1 x 0.07)) x 0.1
Net earnings = $48.80

Therefore, the net earnings for the shareholder are the same under both scenarios - $48.80.

Assume an Initial Scenario Where a Levered Firm Has Total