Donat Corp. is a small company looking at two possible capital structures. Currently, the firm is an all-equity firm with $600,000 in assets and 100,000 shares outstanding. The market value of each share is $6.00
The CEO of Donat is thinking of leveraging the firm by selling $300,000 of debt financing and retiring 50,000 shares, leaving 50,000 shares outstanding. The cost of debt is 5% annually, and the current corporate tax rate for Donat is 30%. The CEO believes that Donat will earn $50,000 per year before interest and taxes. Which of the statements below is TRUE?
A) All-equity EPS is $0.35.
B) 50/50 debt-to-equity EPS is $0.49.
C) Shareholders will be better off by $0.14 per share under a firm with $300,000 in debt financing versus a firm that is all-equity.
D) Statements A, B, and C are all true.
Answer: D
Explanation: D) Find the EPS under the two financing structures with an EBIT of $50,000:
With All-Equity: EPS = = $0.35
Annual Interest Payment for Debt = $300,000 × 0.05 = $15,000.
With 50/50 Debt to Equity: EPS = = $0.49
So the shareholders will be better off by $0.14 per share under a firm with $300,000 in debt financing versus a firm that is all equity. The CEO of Donat Corp. should add debt to the firm as it would benefit the owners of the company.
You might also like to view...
Which of the following is linked to what people think about at work that satisfies them (e.g., advancement, recognition, and achievement)?
A. need for power B. physiological C. hygienes D. motivators
The sales funnel model of classifying prospects involves:
A) assigning each prospect a rating B) using multiple factors to classify prospects C) determining where a prospect is in the sales process D) counting all prospects equally E) asking directed questions to prospects
Which personality test indicates the different ways individuals deal with other people and their environments?
A. Big Five B. Enneagram C. Insights D. Myers-Briggs
The Environmental Protection Agency has concluded that greenhouse gases, including carbon dioxide emissions, do not constitute a public danger.
Answer the following statement true (T) or false (F)