Question 16.S-TP.1: EBIT and EPS Suppose the BDJ Corporation has decided in favo...
EBIT and EPS Suppose the BDJ Corporation has decided in favor of a capital restructuring that involves increasing its existing $80 million in debt to $125 million. The interest rate on the debt is 9 percent and is not expected to change. The firm currently has 10 million shares outstanding, and the price per share is $45. If the restructuring is expected to increase the ROE, what is the minimum level for EBIT that BDJ’s management must be expecting? Ignore taxes in your answer.
To answer, we can calculate the break-even EBIT. At any EBIT above this, the increased financial leverage will increase EPS. Under the old capital structure, the interest bill is $80 million × .09 = $7,200,000. There are 10 million shares of stock; so, ignoring taxes, EPS is (EBIT − $7.2 million)/10 million.
Under the new capital structure, the interest expense will be $125 million × .09 = $11.25 million. Furthermore, the debt rises by $45 million. This amount is sufficient to repurchase $45 million/$45 = 1 million shares of stock, leaving 9 million outstanding. EPS is thus (EBIT − $11.25 million)/9 million.
Now that we know how to calculate EPS under both scenarios, we set the two calculations equal to each other and solve for the break-even EBIT:
(EBIT − $7.2 million)/10 million = (EBIT − $11.25 million)/9 million
EBIT − $7.2 million = 1.11 × (EBIT − $11.25 million)
EBIT = $47,700,000
Verify that, in either case, EPS is $4.05 when EBIT is $47.7 million.