Consider three companies A. B, and C that are in the same line of business and h
ID: 2767047 • Letter: C
Question
Consider three companies A. B, and C that are in the same line of business and have the same market capitalization of $10,000,000 and the same share prices of $10. Company A has no debt. Company B has $2,000,000 of debt, and Company C has $6,000,000 of debt. Interest rate is 8%. Determine the number of shares of each company. Determine ROA, ROE and Earnings Per Share (EPS) for each company if EBIT is $1,000,000 and there are no taxes Determine EBIT for which ROE and Earnings Per Share of Company A and Company C will be the same. What is ROE and Earnings Per Share of Company B in this case? Suppose we have invested $1000 in company A but would like to have a return us if we have invested in company B. What should we do to achieve this goal? (assume EBIT will be as before) Suppose we have 500 shares of company C but would like to have a return as if we have invested in company A. What should we do to achieve this goal? (assume EBIT will be as before).Explanation / Answer
(a) Number of shares = Capitalization / Share price = $10,000,000 / $10 = 1,000,000 for each company
(b)
(1) ROA = [EBIT - (Debt x Interest rate)] / (Market capitalization + Debt)
Company A: [1,000,000 - 0] / [10,000,000 + 0] = 0.1 = 10%
Company B: [1,000,000 - (2,000,000 x 8%)] / [10,000,000 + 2,000,000]
= [1,000,000 - 160,000] / 12,000,000 = 840,000 / 12,000,000 = 0.07 = 7%
Company C: [1,000,000 - (6,000,000 x 8%)] / [10,000,000 + 6,000,000]
= [1,000,000 - 480,000] / 16,000,000 = 520,000 / 16,000,000 = 0.0325 = 3.25%
(2) ROE = [EBIT - (Debt x Interest rate)] / Market capitalization
Company A: [1,000,000 - 0] / [10,000,000 + 0] = 0.1 = 10%
Company B: [1,000,000 - (2,000,000 x 8%)] / 10,000,000
= [1,000,000 - 160,000] / 10,000,000 = 840,000 / 10,000,000 = 0.084 = 8.4%
Company C: [1,000,000 - (6,000,000 x 8%)] / 10,000,000
= [1,000,000 - 480,000] / 10,000,000 = 520,000 / 10,000,000 = 0.052 = 5.2%
(3) EPS ($) = [EBIT - (Debt x Interest rate)] / Number of shares
Company A: [$1,000,000 - 0] / 10,000,000 = $0.10 per share
Company B: $[1,000,000 - (2,000,000 x 8%)] / 10,000,000
= $[1,000,000 - 160,000] / 10,000,000 = $840,000 / 10,000,000 = $0.084 per share
Company C: $[1,000,000 - (6,000,000 x 8%)] / 10,000,000
= $[1,000,000 - 480,000] / 10,000,000 = $520,000 / 10,000,000 = $0.052 per share
Note: First two multi-part sub-questions are answered.