Garson Corp. is looking at two possible capital structures. Currently, the firm is an all-equity firm with $1.2 million dollars in assets and 200,000 shares outstanding. The market value of each share of stock is $6.00
The CEO of Garson is thinking of leveraging the firm by selling $600,000 of debt financing and retiring 100,000 shares, leaving 100,000 outstanding. The cost of debt is 10% annually, and the current corporate tax rate for Garson is 30%. If the CEO believes that Garson will earn $100,000 per year before interest and taxes, should she leverage the firm? Explain.
What will be an ideal response?
Answer: Find the EPS under the two financing structures with an EBIT of $100,000:
With All-Equity EPS = = $0.35
Annual Interest Payment for Debt = $600,000 × 0.10 = $60,000.
With 50/50 Debt-to-Equity: EPS = = $0.28.
So the shareholders will be worse off by $0.07 per share under a firm with $600,000 in debt financing versus a firm that is all-equity. The CEO of Garson Corp. should NOT add this much debt to the firm as it would not benefit the owners of the company. The CEO might look at smaller amounts of debt to determine if debt can be valuable. Smaller amounts of debt might lower the cost of debt borrowing and make leverage value-enhancing for shareholders.
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