Question

You work as a financial analyst for a new subsidiary of Coca-Cola and you are analyzing the new firm’s capital structure. As you move through the data you try to answer the following to your boss

You propose using no debt in the capital structure . Total invested capital is 50 million, Net income is 8 million and outstanding shares are 10 million. What are the EPS and ROE respectively?

1. a. $.40 and 16%

   b. $1 and 20%

   c. $.80 and 16%

   d. cannot be determined

2. Now assume there is 30% debt in the capital structure at a 5% coupon rate which makes net income 7.4 million, and this will reduce the outstanding shares and equity proportionately. What are the EPS and ROE now?

a. $.80 and 16%

b.$1.06 and 16%

c. $.80 and 21%

d. $1.06 and 21%

Answer 1

A)The calculation of EPS and ROE is shown below:

EPS= Net income/no. of shares outstanding = $8 million/$10million = $0.80

ROE= Net income/ Invested capital= $8million/$50 million *100= 16%

So correct answer is C) $0.80 and 16%

B)The calculation of EPS and ROE is shown below:

EPS= Net income/no. of shares outstanding = $7.4 million/7 million = $1.06

ROE= Net income/ Invested capital(Equity) = $7.4 million/($50 million *(1-30%)) =$7.4 million/$35 million * 100 = 21%

So correct answer is d) $1.06 and 21%

number of shares outstanding = (total capital - debt capital)/price per shares

= ($50 million - $15 million)/($50million/10 million)

= 7 million