Problem
Financial theory states that the use of debt financing (also called financial leverage) increases the borrowing firm's earnings per share (EPS)-assuming that everything else remains constant. Use the following example to prove or disprove the hypothesis:Assume that Edinburgh Exports generates annual sales of $875,000 using total assets of $500,000. It has an operating profit margin (EBIT/sales) of 45%, a tax rate of 35%, and 100,000 shares of common stock outstanding. These shares have a par value of $5 per share. Currently, the company is financed solely with common stock, but its management is considering selling sufficient debt to bring its debt ratio to 45%. These debt securities, which will carry an interest rate of 15%, will be used to repurchase an equal value of shares of common stock, with the shares valued at their par value. Given this information, answer the questions in the following table:
Presale Information
• What is the firm's current net income?
• What is the firm's current earnings per share?
Postsale Information
• How many shares of common stock will the firm have outstanding if it sells its new debt?
• What will be the firm's earnings per share if it sells the new debt?