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Calculating EPS under different options

Santos, Inc. currently has no debt and 30,000 shares outstanding. Current share price is $12. Management projects that EBIT is $36,000 if the economic condition is normal (the probability is 0.5), $45,000 if the economy is strong (probability 20%), and $27,000 if a recession occurs (probability 30%).

Santos is considering a refinancing plan that replaces some equity with debt. The corporate finance department proposes a new debt issuance of $120,000 with an annual yield of 10%. The proceeds will be used to repurchase some of the shares outstanding. Santos has a corporate tax rate of 40%.

(a) Use the following template to calculate the EPS under each economic scenario and the expected EPS for the firm before and after restructuring. Which capital structure is better?

Unlevered Firm (D=0)
Type of Economy Boom Normal Bust
Probability 0.3 0.5 0.2
EBIT 45,000 36,000 27,000
Interest
Earnings before taxes
Taxes (40%)
Net income
EPS
Expected EPS
Standard deviation of EPS

Levered Firm (D=$120,000)
Type of Economy Boom Normal Bust
Probability 0.3 0.5 0.2
EBIT 45,000 36,000 27,000
Interest
Earnings before taxes
Taxes (40%)
Net income
EPS
Expected EPS
Standard deviation of EPS

(b)Redo the above calculation assuming equal probabilities for the different economic conditions. Which capital structure do you choose in this case?

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Solution:

(a)Use the following template to calculate the EPS under each economic scenario and the
expected EPS for the firm before and after restructuring. Which capital structure is
better?

Unlevered Firm (D=0)
Type of Economy Boom Normal Bust
Probability 0.3 0.5 0.2
EBIT 45,000 36,000 27,000
Interest 0 0 0
Earnings before taxes 45,000 36,000 27,000
Taxes (40%) 18000 14400 10800
Net income 27,000 21,600 16,200
EPS 0.9 0.72 0.54
Expected EPS 0.738
Standard deviation of ...

Solution Summary

The solution describes the steps for calculating EPS for levered and unlevered structures.

$2.19