The Andersen Corporation is considering the use of debt to increase its rate of return to common stockholders. The firm presently has no debt and 100,000 share of common stock outstanding for a total capitalization of $1,000,000. The firm has no current liabilities so total assets also equal $1,000,000.
It has been suggested by the Chief Financial Officer that the firm borrow $500,000 at 10% and retire 50,000 of it common shares. The shares are selling at $10 in the secondary market.
If the firm expects EBIT of $100,000 in the future, would this be a good idea? Why or why not? Assume a 50% tax rate and show your explicit quantitative reasoning. Be sure to consider such things at EPS, Debt Ratio, Risk, Degree of Financial Leverage, and the Rate of Return on Stockholders Equity.
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This solution explains how to determine capital structure for The Andersen Corporation.