Question: The StayDry Umbrella Corporation will have an EBIT of $100,000 if there is a normal amount of rain this year. But if there is a drought, they will have an EBIT of only $50000. The interest rate on debt is 10%, and the tax rate they pay is 35%. They do not pay any preferred dividends.
A) If StayDry has zero debt and 50,000 outstanding shares, what will their EPS (earnings per share) be if there is normal rain? What will their EPS be if there is a drought? What is their DFL (degree of financial leverage)?
B) Now suppose StayDry has decided to take on $300,000 in debt and has used these funds to buy pack half of the outstanding shares so now there are only 25,000 outstanding shares. What is the new EPS and DFL for both normal rain and drought?
C) Based on your answers to a) and b) above, what are the trade-offs management has to make between zero debt or $300,000 in debt? What are the benefits and disadvantages of taking on this debt?