Ben Ten Limited (BTL) is a new company and management are trying to decide on a financing structure. They want to raise $10,000,000. They were offered the following option:

Fund 60% of the firm with debt and the balance with ordinary shares at an issue price of $2 per share. BTL has been advised that the cost of debt finance would be 2.72%pa due to its relative risk.

The current Earnings Before Interest and Tax (EBIT) is $8,000,000

The company tax rate is 30%.

Calculate the Earnings Per Share of this option (Round your answer to 2 decimal places. For example, if your answer is 0.66666666 - Enter your answer as 0.67)

Question

Ben Ten Limited (BTL) is a new company and management are trying to decide on a financing structure.  They want to raise $10,000,000. They were offered the following option:

Fund 60% of the firm with debt and the balance with ordinary shares at an issue price of $2 per share. BTL has been advised that the cost of debt finance would be 2.72%pa due to its relative risk.

The current Earnings Before Interest and Tax (EBIT) is $8,000,000

The company tax rate is 30%.

Calculate the Earnings Per Share of this option (Round your answer to 2 decimal places. For example, if your answer is 0.66666666 -> Enter your answer as 0.67)

BlackTom AI · Accepted Answer

To tackle this question, begin by identifying the financing mix and the resulting number of shares to be issued.
- The plan is to fund 60% of the $10,000,000 with debt, which equals 6,000,000 in debt. The remaining 40% is financed with ordinary shares, equaling 4,000,000 in equity value.
- At an issue price of $2 per share, the number of new ordinary shares issued = 4,000,000 / 2 = 2,000,000 shares.

Next, compute the annual interest expense on the debt.
- Interest expense = debt amount × cost of debt = 6,000,000 × 0.0272 = 163,200.

Now move to after-tax earnings to determine net income.
- EBIT is 8,000,000. Subtract interest to obtain earnings before tax (EBT): EBT = 8,000,000 − 163,200 = 7,836,800.
- Tax at 30%: Tax = 0.30 × 7,836,800 = 2,351,040.
- Net income = EBT − Tax = 7,836,800 − 2,351,040 = 5,485,760.

Compute earnings per share (EPS).
- Shares outstanding from the equity issue = 2,000,000.
- EPS = Net income / Shares = 5,485,760 / 2,000,000 = 2.74288, which rounds to 2.74 when given to two decimals.

Consider potential sources of discrepancy.
- If someone incorrectly treated the after-tax cost of debt or tax shield differently, or used a different debt/equity split, the EPS value would change.
- The provided answer (3.51) does not align with the straightforward computation under the stated assumptions, which yields 2.74.

In summary, applying the standard formulae for levered EPS with debt financing at 2.72% and a 30% tax rate leads to an EPS of approximately 2.74 per share, given 2,000,000 shares outstanding.

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