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.
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