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Beaver Co has 100 million equity shares in issue and has just reported a profit, after tax, of $55m.
A new issue of 50 million equity shares at an issue price of $1.50 is being considered. All proceeds would be used to redeem a bank loan with an annual cost of 8%. Beaver Co pays corporation tax at a rate of 20%.
Assume that operating profit (profit before interest and tax) remains constant. If the equity issue goes ahead and the bank loan is redeemed, what will be the new earnings per share figure?A0.399
B0.367
C0.598
D0.388All my calculations are correct, except I subtract net interest cost from PAT rather than adding it and I don’t understand as to why we treat it as a saving? Do we not have a bank loan for which we would be making interest payments that should reduce the PAT?
Please let me know, thank you in advance!
When Beaver Co redeems the bank loan using the proceeds from the new equity issue, it effectively eliminates the interest expense associated with that loan.
The interest cost is treated as a saving because, after redeeming the loan, the company will no longer incur that interest expense, which would have otherwise reduced the profit after tax.
So you add the after-tax savings from the interest expense back to the profit before tax to arrive at the new earnings figure (a higher earnings per share figure).
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