The question:
DESDES Ventures is considering using debt to repurchase equity. You are given the following information:
- DESDES’s earnings before interest and taxes are $800,000, none of which would be affected by a share repurchase.
- DESDES has $1,000,000 of outstanding debt, with annual coupon payments of $50,000.
- DESDES has 100,000 shares outstanding, at a market value of $40/share.
- Tax rate is 40%.
If DESDES repurchases 30,000 shares at $45/share (financing with debt at an after-tax rate of 5%), DESDES’s new EPS is closest to: 4.8, 4.5, 5.5
My solution:
Earnings = (800,000-50,000)*.6 = 450,000
The new debt would be 30,000*45 = $1,350,000 to repurchase shares. That would be $1,350,000*.05=$67,500 in debt repayment each year. So new EPS would be (450,000-67,500)/70,000=5.46.
Is that correct?