Tortuga, Inc. is looking to raise $2 million for new equipment
to enhance the efficiency of its operations. The firm currently is
capitalized with 100,000 shares of equity at a market price of $42
per share and also has $1,000,000 of debt with an interest rate of 8%. The company believes that with the new capital they could achieve an EBIT of $500,000. Assume new equity could be issued at current market price and that new debt would still carry a 8% coupon. The company has a 25% marginal tax rate. Should Tortuga issue Equity or Debt?
Group of answer choices
Equity, because EPS will be $2.72
Debt, because EPS will be $2.88
Equity, because EPS will be $2.13
Debt, because EPS will be $1.95
To determine whether Tortuga should issue equity or debt, we need to compare the expected EPS (Earnings per Share) for each scenario.
First, let's calculate the earnings before interest and taxes (EBIT) assuming the new capital is obtained:
EBIT = $500,000
Next, let's calculate the interest expense for the debt:
Interest Expense = $1,000,000 * 8% = $80,000
Now, let's calculate the earnings before taxes (EBT) for each scenario:
EBT_equity = EBIT - Interest Expense = $500,000 - $80,000 = $420,000
EBT_debt = EBIT - Interest Expense = $500,000 - $80,000 = $420,000
Next, let's calculate the earnings after taxes (EAT) for each scenario:
EAT_equity = EBT_equity * (1 - Tax Rate) = $420,000 * (1 - 0.25) = $315,000
EAT_debt = EBT_debt * (1 - Tax Rate) = $420,000 * (1 - 0.25) = $315,000
Now, let's calculate the number of shares outstanding after issuing new equity:
New Shares = $2,000,000 / $42 = 47,619 shares
Now, let's calculate the EPS for each scenario:
EPS_equity = EAT_equity / (100,000 + New Shares) = $315,000 / (100,000 + 47,619) = $1.95
EPS_debt = EAT_debt / 100,000 = $315,000 / 100,000 = $3.15
Therefore, Tortuga should issue debt because the EPS will be $3.15, which is higher than the EPS of $1.95 that would result from issuing equity. So, the correct answer is: Debt, because EPS will be $2.88.
To determine whether Tortuga, Inc. should issue equity or debt, we need to calculate the impact on earnings per share (EPS) for each option.
First, let's calculate the current EPS before raising new capital.
Current Earnings Before Interest and Taxes (EBIT) = $500,000
Taxes = 25% of EBIT = $500,000 * 0.25 = $125,000
Net Income = EBIT - Taxes = $500,000 - $125,000 = $375,000
Number of Shares = 100,000
EPS = Net Income / Number of Shares = $375,000 / 100,000 = $3.75
Now, let's determine the impact of issuing equity:
New Equity Raised = $2,000,000
Market Price per Share = $42
Number of New Shares Issued = New Equity Raised / Market Price per Share = $2,000,000 / $42 = 47,619 shares
New Total Shares = Number of Shares + Number of New Shares Issued = 100,000 + 47,619 = 147,619 shares
New Net Income = EBIT - Taxes = $500,000 - $125,000 = $375,000
New EPS = New Net Income / New Total Shares = $375,000 / 147,619 ≈ $2.54
Now, let's determine the impact of issuing debt:
New Debt Raised = $2,000,000
Interest Expense = New Debt Raised * Interest Rate = $2,000,000 * 0.08 = $160,000
New Net Income = EBIT - Taxes - Interest Expense = $500,000 - $125,000 - $160,000 = $215,000
New EPS = New Net Income / Number of Shares = $215,000 / 100,000 = $2.15
Comparing the options, we can see that issuing debt would result in a higher EPS of $2.15, whereas issuing equity would result in a lower EPS of $2.54.
Therefore, Tortuga, Inc. should issue debt, because the EPS will be $2.15 under this option.
The correct answer is: Debt, because EPS will be $2.15.