ABC Corp Ltd has 10 million shares and $600,000 of debt (issues bonds @ 7% p.a.). EBIT is projected to be $3 million. The company tax rate is 20%.Preference shares pay an annual dividend of $100,000. Management is considering two options for capital restructure:
Option 1: The Company would borrow $3.5 million at 8% interest rate and use the proceeds to engage in share repurchase program for 3.5 million shares at the current market price of $1.
Option 2: Company can raise $3.5 million by issuing new shares at the current market price of $1.
Required:
a) What is the current EPS for shareholders? (5 marks)
b) What will be the EPS after the change in capital structure under option 1
and option 2? Hint: show full working from EBIT to Net Profit (12 marks)
c) Does it make sense for management to go ahead with either of the capital restructure options? If yes, which of the two options is EPS accretive?
(2 marks)
d) What is meant by the term ‘capital str respect to Weighted Cost of Capital (WACC) and the value of the firm
define an optimal capital structure? (6 marks)
That's your entire assignment -- not a single thought of your own.
IF there's an accounting tutor on Jiskha somewhere, what questions do YOU have about your assignment?
To answer these questions, we need to calculate various financial ratios and make some assumptions. Let's break down the questions step by step:
a) To calculate the current EPS (Earnings per Share), we need to divide the earnings available to common shareholders by the number of outstanding shares. The earnings available to common shareholders can be calculated as follows:
Earnings before interest and taxes (EBIT) - Interest expense on debt - Taxes on earnings = Earnings available to common shareholders
Given:
EBIT = $3 million
Debt = $600,000
Interest rate on debt = 7%
Tax rate = 20%
Step 1: Calculate interest expense on debt:
Interest Expense = Debt * Interest Rate = $600,000 * 7% = $42,000
Step 2: Calculate taxes on earnings:
Taxes = EBIT * Tax Rate = $3 million * 20% = $600,000
Step 3: Calculate earnings available to common shareholders:
Earnings available to common shareholders = EBIT - Interest Expense - Taxes = $3 million - $42,000 - $600,000 = $2,358,000
b) To calculate the EPS after the change in capital structure, we need to consider options 1 and 2 separately.
Option 1: Share repurchase using borrowed funds:
In this case, the company borrows $3.5 million at 8% interest rate. We assume that the interest expense on the new debt will be $0. Since the company repurchases 3.5 million shares at $1 each, the number of outstanding shares will decrease.
Step 1: Calculate the new number of outstanding shares:
Current number of shares = 10 million
Repurchased shares = 3.5 million
New number of shares = Current number of shares - Repurchased shares = 10 million - 3.5 million = 6.5 million
Step 2: Calculate the new EPS:
EPS = Earnings available to common shareholders / New number of shares = $2,358,000 / 6.5 million
Option 2: Issuing new shares:
In this case, the company raises $3.5 million by issuing new shares at $1 each. We assume that there are no issuance costs.
Step 1: Calculate the new number of shares:
Current number of shares = 10 million
New shares issued = 3.5 million
New number of shares = Current number of shares + New shares issued = 10 million + 3.5 million = 13.5 million
Step 2: Calculate the new EPS:
EPS = Earnings available to common shareholders / New number of shares = $2,358,000 / 13.5 million
c) To determine if either of the capital restructure options make sense, we compare the new EPS with the current EPS.
If the new EPS is higher than the current EPS, it indicates EPS accretion, meaning the restructure has a positive impact on EPS.
d) The term "capital structure" refers to the combination of debt and equity used to finance a company's operations. The weighted cost of capital (WACC) is the average cost of the company's debt and equity.
The value of the firm is the market value of the company's equity and debt combined.
An optimal capital structure is the mix of debt and equity that minimizes the company's WACC and maximizes the value of the firm. This is achieved when the cost of capital is minimized, and the firm's value is maximized to benefit shareholders. The optimal capital structure varies for different companies based on their risk profile, industry norms, and market conditions.