ABC Corp Ltd has 10 million shares and $600,000 of debt (issues bonds @ 7% p.a.). EBIT is projected to be $3 million. The company tax rate is 20%.Preference shares pay an annual dividend of $100,000. Management is considering two options for capital restructure:

Question

Option 1: The Company would borrow $3.5 million at 8% interest rate and use the proceeds to engage in share repurchase program for 3.5 million shares at the current market price of $1.
Option 2: Company can raise $3.5 million by issuing new shares at the current market price of $1.
Required:
a) What is the current EPS for shareholders? (5 marks)
b) What will be the EPS after the change in capital structure under option 1 and option 2? Hint: show full working from EBIT to Net Profit (12 marks)
c) Does it make sense for management to go ahead with either of the capital restructure options? If yes, which of the two options is EPS accretive? (2 marks)
d) What is meant by the term ‘capital structure’ and what circumstances with respect to Weighted Cost of Capital (WACC) and the value of the firm define an optimal capital structure? (6 marks)

Answer 1

ABC Corp Ltd has 10 million shares and $600,000 of debt (issues bonds @ 7% p.a.). EBIT is projected to be $3 million. The company tax rate is 20%.Preference shares pay an annual dividend of $100,000. Management is considering two options for capital restructure:
Option 1: The Company would borrow $3.5 million at 8% interest rate and use the proceeds to engage in share repurchase program for 3.5 million shares at the current market price of $1.
Option 2: Company can raise $3.5 million by issuing new shares at the current market price of $1.
Required:
a) What is the current EPS for shareholders? (5 marks)
b) What will be the EPS after the change in capital structure under option 1 and option 2? Hint: show full working from EBIT to Net Profit (12 marks)
c) Does it make sense for management to go ahead with either of the capital restructure options? If yes, which of the two options is EPS accretive? (2 marks)
d) What is meant by the term ‘capital structure’ and what circumstances with respect to Weighted Cost of Capital (WACC) and the value of the firm define an optimal capital structure? (6 marks)