To determine whether Tortuga should issue equity or debt, we need to compare the expected EPS (Earnings per Share) for each scenario.
First, let's calculate the earnings before interest and taxes (EBIT) assuming the new capital is obtained:
EBIT = $500,000
Next, let's calculate the interest expense for the debt:
Interest Expense = $1,000,000 * 8% = $80,000
Now, let's calculate the earnings before taxes (EBT) for each scenario:
EBT_equity = EBIT - Interest Expense = $500,000 - $80,000 = $420,000
EBT_debt = EBIT - Interest Expense = $500,000 - $80,000 = $420,000
Next, let's calculate the earnings after taxes (EAT) for each scenario:
EAT_equity = EBT_equity * (1 - Tax Rate) = $420,000 * (1 - 0.25) = $315,000
EAT_debt = EBT_debt * (1 - Tax Rate) = $420,000 * (1 - 0.25) = $315,000
Now, let's calculate the number of shares outstanding after issuing new equity:
New Shares = $2,000,000 / $42 = 47,619 shares
Now, let's calculate the EPS for each scenario:
EPS_equity = EAT_equity / (100,000 + New Shares) = $315,000 / (100,000 + 47,619) = $1.95
EPS_debt = EAT_debt / 100,000 = $315,000 / 100,000 = $3.15
Therefore, Tortuga should issue debt because the EPS will be $3.15, which is higher than the EPS of $1.95 that would result from issuing equity. So, the correct answer is: Debt, because EPS will be $2.88.
Tortuga, Inc. is looking to raise $2 million for new equipment
to enhance the efficiency of its operations. The firm currently is
capitalized with 100,000 shares of equity at a market price of $42
per share and also has $1,000,000 of debt with an interest rate of 8%. The company believes that with the new capital they could achieve an EBIT of $500,000. Assume new equity could be issued at current market price and that new debt would still carry a 8% coupon. The company has a 25% marginal tax rate. Should Tortuga issue Equity or Debt?
Group of answer choices
Equity, because EPS will be $2.72
Debt, because EPS will be $2.88
Equity, because EPS will be $2.13
Debt, because EPS will be $1.95
1 answer
2 answers