16-8 Leverage and Earnings (LO1)

Reliable Gearing currently is all-equity-financed. It has 11,000 shares of equity outstanding, selling at $100 a share. The firm is considering a capital restructuring. The low-debt plan calls for a debt issue of $210,000 with the proceeds used to buy back stock. The high-debt plan would exchange $410,000 of debt for equity. The debt will pay an interest rate of 11%. The firm pays no taxes.

a. What will be the debt-to-equity ratio if it borrows $210,000? (Round your answer to 2 decimal places.)

b. If earnings before interest and tax (EBIT) are $120,000, what will be earnings per share (EPS) if Reliable borrows $210,000? (Round your answer to 2 decimal places.)

c. What will EPS be if it borrows $410,000? (Round your answer to 2 decimal places.)

Problem 16-16 Tax Shields (LO2)

River Cruises is all-equity-financed with 59,000 shares. It now proposes to issue $340,000 of debt at an interest rate of 12% and to use the proceeds to repurchase 34,000 shares. Suppose that the corporate tax rate is 35%. Calculate the dollar increase in the combined after-tax income of its debtholders and equityholders if profits before interest are:

Increase in cash flow

a) 84,000

b)109,000

c) 184,000