Problem:
Show how leverage increases financial risk by calculating the EPS and return on shares for a firm with $1 million in 10% debt. The firm also has 50,000 shares outstanding that sell for $40 each. Three states of the economy are possible: a slump under which the firm would have operating income of $150,000, a normal state under which the firm will earn $420,000, and a boom under which the firm will earn $600,000. The firm pays no taxes.
LiveBetter can choose between the two following issues: A public issue of $10 million face value of 10-year debt. The interest rate on the debt would be 8.5 percent and the debt would be issued at face value. The underwriting spread would be 1.5 percent and other expenses would be $80,000. OR A private placement of $10 million face value of 10-year debt. The interest rate on the debt would be 9 percent and the total issuing expenses would be $30,000.
Which deal should LiveBetter choose?