Reliable Gearing currently is all-equity-financed. It has 10,000 shares
of equity outstanding, selling at $100 a share. The firm is considering
a capital restructuring. The low-debt plan calls for a debt issue of
$230,000 with the proceeds used to buy back stock. The high-debt plan
would exchange $400,000 of debt for equity. The debt will pay an
interest rate of 10.0%. The firm pays no taxes.
Required:
a. What will be the debt-to-equity ratio after each contemplated restructuring?
b-1. If earnings before interest and tax (EBIT) will be either
$75,000 or $175,000, what will be earnings per share for each financing
mix for both possible values of EBIT?
b-2. If both scenarios are equally likely, what is expected (i.e., average) EPS under each financing mix?
b-3. Is the high-debt mix preferable?
c. Suppose that EBIT is $100,000. What is EPS under each financing mix?
