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
Answer:
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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