Gabella's is an all-equity firm that has 36,000 shares of stock outstanding at a market price of $27 a share. The firm has earnings before interest and taxes of $57,600 and has a 100 percent dividend payout ratio. Ignore taxes. Gabella's has decided to issue $125,000 of debt at a rate of 9 percent and use the proceeds to repurchase shares. Terry owns 800 shares of Gabella's stock and has decided to continue holding those shares. How will Gabella's debt issue affect Terry's annual dividend income?

Terry's annual dividend income will aecrease from $640 to $591

Explanation:

Given

Earnings before interest and taxes = $57,600

Market Price Share = $27

Stock = 36,000 shares

Debt = $125,000

Debt rate = 9%

First, we calculate the all equity Earnings per share

This is calculated by dividing earnings by outstanding stock

All-equity EPS = $57,600/36,000

All equity EPS = $1.60

Then we calculate the Debt and equity EPS

This is calculated by (Earnings - Debt * Debt Rate) / (Stock - Debt/Market Price Share)

Debt and equity EPS = [$57,600 - ($125,000 *.09) ]/[36,000 - ($125,000/$27) ]

Debt and Equity EPS = $1.4775

Calculating Terry's all-equity dividend income

= 400 * $1.60 = $640

Calculating Terry's debt and equity dividend income

= 400 * $1.4775 = $591

Terry's annual dividend income will aecrease from $640 to $591