Landry 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 stock is $6.00
The CEO of Landry 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 Landry is 30%. If the CEO believes that Landry's EBIT will be $120,000, should the CEO leverage the firm? Explain.
What will be an ideal response?
Answer: Find the EPS under the two financing structures with an EBIT of $120,000:
With All-Equity EPS = = $0.42
Annual Interest Payment for Debt = $600,000 × 0.10 = $60,000.
With 50/50 Debt-to-Equity: EPS = = $0.42
Because the earnings per share are the same, the shareholders will be indifferent as to whether the CEO chooses $600,000 in debt financing versus a firm that is all-equity. Thus, it does not matter what the CEO chooses.
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