Question
Neo Company has made the following forecast of sales, with the associated probabilities of occurrence noted. Sales Probability $300,000 0.20 400,000 0.60 500,000 0.20 The
Neo Company has made the following forecast of sales, with the associated probabilities of occurrence noted. Sales Probability $300,000 0.20 400,000 0.60 500,000 0.20 The company has fixed operating costs of $105,000 per year, and variable operating costs represent 45% of sales. The existing capital structure consists of 26,000 shares of common stock that have a $10 per share book value. No other capital items are outstanding. The company is contemplating shifting its capital structure by substituting debt in the capital structure for common stock. The two different debt ratios under consideration are shown in the following table, along with an estimate, for each ratio, of the corresponding required interest rate on all debt. Debt Ratio Interest rate on all debt 30% 12% 60 15 The tax rate is 40%. a. Calculate the expected earnings per share (EPS), the standard deviation of EPS, and the coefficient of variation of EPS for the two proposed capital structures. b. Determine the optimal capital structure through maximization of earnings per share.
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