Question

Kaelea, Inc., has no debt outstanding and a total market value of $120,000. Earnings before interest and taxes, EBIT, are projected to be $9,200 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 22 percent higher. If there is a recession, then EBIT will be 33 percent lower. The company is considering a $37,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 4,800 shares outstanding. Assume the company has a tax rate of 35 percent. a. Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.) EPS Recession $ Normal $ Expansion $ b. Calculate the percentage changes in EPS when the economy expands or enters a recession. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answers as a percent rounded to the nearest whole number, e.g., 32.) %ΔEPS Recession % Expansion % Assume the company goes through with recapitalization. c. Calculate earnings per share, EPS, under each of the three economic scenarios after the recapitalization. (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.) EPS Recession $ Normal $ Expansion $ d. Calculate the percentage changes in EPS when the economy expands or enters a recession.

Answer 1

Normal:

EBIT = $9,200

Recession:

EBIT = $9,200 - 33% * $9,200
EBIT = $6,164

Expansion:

EBIT = $9,200 + 22% * $9,200
EBIT = $11,224

Answer a.

Total Value = $120,000
Number of shares outstanding = 4,800

Price per share = Total Value / Number of shares outstanding
Price per share = $120,000 / 4,800
Price per share = $25.00

Recession $ 6,164.00$ EBIT Less: Interest Expense EBT Less: Taxes (35%) Net Income # of Shares EPS $ $ $ 6,164.00$ 2,15740$ 4,006.60 $ 4.800 0.83 $ Normal Expansion 9,200.00 $ 11,224.00 S 9,200.00 $ 11,224.00 3,220.00$ 3,928.40 5,980.00 $ 7,295.60 4.800 4,800 1.25 $ 1.52 $

Answer b.

If economy expand:

Percentage Change in EPS = ($1.52 - $1.25) / $1.25
Percentage Change in EPS = 22%

If economy collapse:

Percentage Change in EPS = ($0.83 - $1.25) / $1.25
Percentage Change in EPS = -34%

Answer c.

Value of Debt = $37,000

Interest Expense = 6% * $37,000
Interest Expense = $2,220

Value of Equity = $83,000
Price per share = $25.00

Number of shares outstanding = $83,000 / $25.00
Number of shares outstanding = 3,320

Less: Interest Expense EBT Less: Taxes Net Income # of Shares EPS Recession $ 6,164.00 $ $ 2,220.00 $ $ 3,944.00$ $ 1,380.40 $ $ 2,563.60 $ 3,320 $ 0.77 $ Normal Expansion 9,200.00 $ 11,224.00 2,220.00 $ 2,220.00 6,980.00 $ 9,004.00 2,443.00 $ 3,151.40 4,537.00 $ 5,852.60 3,320 3,320 1.37 $ 1.76

Answer d.

If economy expand:

Percentage Change in EPS = ($1.76 - $1.37) / $1.37
Percentage Change in EPS = 29%

If economy collapse:

Percentage Change in EPS = ($0.77 - $1.37) / $1.37
Percentage Change in EPS = -44%