P13-2 Expected EPS after Leveraging

A. Mac-N-Cheese, Inc., doesnt face any taxes and has $290 million in assets, currently financed entirely with equity. Equity is worth $40 per share, and book value of equity is equal to market value of equity. Also, lets assume that the firms expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities as shown below:

STATE RECESSION AVERAGE BOOM

Probability of state 0.25 0.55 0.20

Expected EBIT in state $5 million $10 million $17 million

What is their expected EPS?

Expected Earnings = sum of (probability x Expected Earnings)

# of shares = Total Asset Value/Price per share

EPS = Expected Earnings/# Shares

A. The firm is considering switching to a 20-percent debt capital structure, and has determined that they would have to pay an 8 percent yield on perpetual debt in either event. Assume the share price does not change.

What will be the expected EPS if they switch to the proposed capital structure?

You need to subtract the interest from EBIT to get earnings

Interest = % debt x rate x firm value

Also note that the number of shares will be

(% equity x firm value)/price per share

Then follow the procedure in part A.

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