Reliable Gearing currently is all-equity-financed. It has 14,000 shares of equity outstanding

Reliable Gearing currently is all-equity-financed. It has 14,000 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 $300,000 with the proceeds used to buy back stock. The high-debt plan would exchange $300,000 of debt for equity. The debt will pay an interest rate of 10.4%. The firm pays no taxes.

a.	What will be the debt-to-equity ratio after each contemplated restructuring? (Round your answers to 2 decimal places.)

	Debt-to-Equity Ratio
Low-debt plan
High-debt plan

b-1.	If earnings before interest and tax (EBIT) will be either $110,000 or $160,000, what will be earnings per share for each financing mix for both possible values of EBIT? (Round your answers to 2 decimal places.)

	Earnings Per Share
EBIT	Low-Debt Plan	High-Debt Plan
$110,000	$	$
$160,000

b-2.	If both scenarios are equally likely, what is expected (i.e., average) EPS under each financing mix? (Do not round intermediate calculations. Round your answers to 2 decimal places.)

	Earnings Per Share
Low-debt plan	$
High-debt plan

b-3.	Is the high-debt mix preferable?
	No

c.	Suppose that EBIT is $145,600. What is EPS under each financing mix? (Round your answers to 2 decimal places.)

	Earnings Per Share
Low-debt plan	$
High-debt plan

Explanation:

Some values below may show as rounded for display purposes, though unrounded numbers should be used for the actual calculations.

a.

Market value of the firm is $100 × 14,000 = $1,400,000.

With the low-debt plan, equity falls by $300,000, so:

D/E = $300,000/$1,100,000 = 0.27

11,000 shares remain outstanding.

With the high-debt plan, equity falls by $300,000, so:

D/E = $300,000/$1,100,000 = 0.27

11,000 shares remain outstanding.

b.

Low-debt plan:

EBIT	$110,000	$160,000
Interest	31,200	31,200
Equity earnings	78,800	128,800
EPS [earnings/11,000]	7.16	11.71

Expected EPS = ($7.16 + $11.71)/2 = $9.44

High-debt plan:

EBIT	$110,000	$160,000
Interest	31,200	31,200
Equity earnings	78,800	128,800
EPS [earnings/11,000]	7.16	11.71

Expected EPS = ($7.16 + $11.71)/2 = $9.44

The high-debt plan results in lower expected EPS, it is preferable because it also entails lower risk. The higher risk shows up in the fact that EPS for the high-debt plan is lower than EPS for the low-debt plan when EBIT is low but EPS for the high-debt plan is higher when EBIT is higher.

c.

	Low-Debt Plan	High-Debt Plan
EBIT	$145,600	$145,600
Interest	31,200	31,200
Equity earnings	114,400	114,400
EPS	10.40	10.40