Tom Inc. has 5,000 shares outstanding that are selling at $5 per share. It also
ID: 2739740 • Letter: T
Question
Tom Inc. has 5,000 shares outstanding that are selling at $5 per share. It also has $25,000 perpetual debts that pay 8% coupon and are trading to yield 5%. Tom is considering to issue new debt perpetual debt of $10,000 at par to repurchase its outstanding stocks. EBIT is expected to be either $3,000 or $9,000 (equal probability) per year forever and tax rate is 30%.
a) What are the possible EPS under the current capital structure?
b) What are the possible EPS under the proposed capital structure?
c) What is the breakeven EBIT between the current and proposed capital structures?
d) If the equity beta and debt beta are 1.44 and 0.2 respectively under the current capital structure, calculate the new equity beta under the proposed capital structure.
Explanation / Answer
Ans) Equity 5000 shares Selling Price 5$ Debt 25000 Cupon Rate 8% Trading yeild 5% New perpectual debt 10000 Prabability EBIT($) 0.5 3000 Per yr forver 0.5 9000 Per yr orever Tax Rate 30% a) Possible EPS under Current capital Structure Equity 25000 Debt 25000 Expected EBIT Probability (1) EBIT(2) Expected EBIT $ (1*2) 0.5 3000 1500 0.5 9000 4500 6000 Particulars Amount ($) Expected EBIT 6000 Less Interest (25000*8%) 2000 EBT 4000 Tax 1200 EAT 2800 Possible EPS under Current capital Structure = 2800/5000 = 0.56 b) Possible EPS under the proposed capital structure Particulars Amount ($) Expected EBIT 6000 Less Interest (25000+10000)*8% 2800 EBT 3200 Tax 960 EAT 2240 Expected EPS under after Proposed Debt = EAT/No of Shares = 0.75 No of Shares before Repurchase = 5000 No of shares repurchase= 10000/5 2000 No of shares after buy back 3000 c) Breakeven EBIT between the current and proposed capital structures EBIT under current capital structure Particulars Amount$ Expected EBIT 6000 Interest (25000+10000)*8% 3600 EBT 2400 Tax 720 EAT 1680 Particulars Amount Interest 3600 8% 3600 100% 45000 Total Debt 45000 Existing Debt 25000 New Debt 20000 If interest is same then Breaken EBIT ( 6000+1600*)= 7600$ *I.e Increanterestse in i3600-2000=1600 d) Existing Equity beta @25000$ 1.44 Equity beat for 100% 2.88 Equity Beta for New proposinate @ 15000$ 2.88*15000/50000 0.864 Existing Debt Beta@ 25000$ Debt 0.2 Equity beat for 100% Debt 0.4 Debt Beta for New proposinate @ 35000$Debt 0.4*35000/50000 0.28