Reliable Gearing currently is all-equity-financed. It has 10,000 shares of equity outstanding, selling at $100 a share. The firm is considering a capital restructuring. The low-debt plan calls for a debt issue of $200,000 with the proceeds used to buy back stock. The high-debt plan would exchange $400,000 of debt for equity. The debt will pay an interest rate of 10%. The firm pays no taxes.
a. What will be the debt-to-equity ratio after each possible restructuring?
b. If earnings before interest and tax (EBIT) will be either $90,000 or $130,000, what will earnings per share be for each financing mix for both possible values of EBIT? If both scenarios are equally likely, what is expected (that is, average) EPS under each financing mix? Is the high-debt mix preferable?
c. Suppose that EBIT is $100,000. What is EPS under each financing mix? Why are they the same in this particular case?
