# Jackson Software, Inc. is an a

Jackson Software, Inc. is an all-equity firm with 2 millionshares outstanding, \$6 million in earnings after taxes, and amarket value of \$100 million. The firm borrows \$25 million at aninterest rate of 8% and buys back 500,000 shares with the proceeds.The firm’s tax rate is 40%. Management does not want the earningsperformance to disappoint shareholders and market analysts. What isthe maximum interest rate the firm could pay on its new debt so asnot to experience a decrease in earnings per share after the stockrepurchase?

Select one:

A. 8.00%

B. 10.00%

C. 11.50%

D. 12.60%

E. None of the above

Jackson Software, Inc. is an all-equity firm with 2 millionshares outstanding, \$6 million in earnings after taxes, and amarket value of \$100 million. The firm borrows \$25 million at aninterest rate of 8% and buys back 500,000 shares with the proceeds.The firm’s tax rate is 40%. What effect will this transaction haveon the firm’s earnings per share?

Select one:

A. EPS will decrease by \$.60 per share

B. EPS will increase by \$.40 per share

C. EPS will decrease by \$.30 per share

D. EPS will increase by \$.20 per share

E. None of the above

1) Current earnings per share = Current earnings after taxes /Current no. of shares = \$6,000,000 / 2,000,000 = \$3 per share

This earnings per share has to be maintained.

New no. of shares = 2,000,000 – 500,000 = 1,500,000

New earnings per share = Old earnings per share

or, New earnings after tax / New no. of shares = \$3

or, New earnings after tax = \$3 x New no. of shares = \$3 x1,500,000 = \$4,500,000

Reduction in earnings after tax that firm can bear = \$6,000,000- \$4,500,000 = \$1,500,000

This is the amount of interest but this is after tax. So –

Before tax interest amount = \$1,500,000 / (1 – tax rate) =\$1,500,000 / (1 – 0.40) = \$2,500,000

Interest rate = (Before tax Interest / borrowing) x 100 =(\$2,500,000 / \$25,000,000) x 100 = 10%

Therefore, the firm can pay a maximum of 10%interest rate on its debt without experiencing a decrease inearnings per share. (option B)

2) Current earnings per share = \$3

Current before tax earnings = \$6,000,000 / (1 – tax rate) =\$6,000,000 / (1 – 0.40) = \$10,000,000

These are the earnings before tax and interest under the newstructure.

 Earnings before tax and interest 10,000,000 Less: Interest (8% x \$25,000,000) 2,000,000 Earnings before tax 8,000,000 Less: tax @40% 3,200,000 Earnings after tax (a) 4,800,000 New no. of shares (b) 1,500,000 New earnings per share \$3.20 Less: Old earnings per share \$3 Increase / (-)Decrease in earnings per share \$0.20

Therefore, earnings per share has increased by \$0.20(option D).

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