Chartered Financial Analyst Level 2
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- An analyst gathers the following information about a company:
- Current share price:
$100 - Latest reported annual earnings after taxes:
$45million - Shares outstanding: 4.5 million
- After-tax cost of debt: 7%
If the company plans to raise $25 million in debt to repurchase 250,000 shares, its EPS after the share repurchase will be closest to:
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A
$9.6
B
$10.2
C
$10.6
Explanation:
Explanation
Step 1: Calculate Initial EPS
- Earnings =
$45,000,000 - Shares outstanding = 4,500,000
- Initial EPS =
$45,000,000 / 4,500,000 =$10.00
Step 2: Calculate Interest Expense
- Debt raised =
$25,000,000 - After-tax cost of debt = 7%
- Interest expense =
$25,000,000 × 7% =$1,750,000
Step 3: Calculate New Earnings
- New earnings = Initial earnings - Interest expense
- New earnings =
$45,000,000 -$1,750,000 =$43,250,000
Step 4: Calculate New Shares Outstanding
- Shares repurchased = 250,000
- New shares outstanding = 4,500,000 - 250,000 = 4,250,000
Step 5: Calculate New EPS
- New EPS =
$43,250,000 / 4,250,000 =$10.176 ≈$10.2
Verification:
- The company is paying
$100per share to repurchase shares - Earnings yield =
$10/$100= 10% - Cost of debt = 7%
- Positive spread of 3% explains why EPS increases from
$10.00to$10.20
Therefore, the EPS after repurchase will be closest to $10.2.
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