Problem 2: Smith & James , has total assets of $20,000,000, EBIT of $2,000,000, preferred dividends of $250,000 and is taxed at a rate of 40%. In an effort to determine the optimal capital structure, the firm has assembled data on the cost of debt, the number of shares of common stock for various levels of indebtedness, and the overall required return on investment:
Cost of
debt, kd
No. of common stock shares Required
return, ks
0.00% 200000 10.00%
10.00% 170000 11.00%
9.00% 150000 12.00%
13.00% 110000 14.00%
11.50% 80000 13.00%
a. Calculate earnings per share for each level of indebtedness.
Use this grid for your answer.
Debt Ratio 0.00% 15.00% 30.00% 45.00% 60.00%
EBIT
Less Interest
EBT
Taxes at 40%
Net Profit
Less Preferred Div
Profits available to
common stockholders
Number of Shares
EPS
b. Calculate the price per share for each level of indebtedness
c. Choose the best capital structure. Why?