Question

unrise, Inc., has no debt outstanding and a total market value of $240,000. Earnings before interest and taxes, EBIT, are projected to be $28,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 12 percent higher. If there is a recession, then EBIT will be 25 percent lower. The company is considering a $140,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 12,000 shares outstanding. Ignore taxes for this problem. Assume the stock price is constant under all scenarios.

a-1.	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.)
a-2.	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 2 decimal places, e.g., 32.16.)
b-1.	Calculate earnings per share (EPS) under each of the three economic scenarios assuming the company goes through with recapitalization. (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)
b-2.	Given the recapitalization, 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 2 decimal places, e.g., 32.16.)

Answer 1

a-1

EPS = EBIT*(1-tax rate)/shares outstanding

Recession

EPS = EBIT*(1-recession impact%)*(1-tax rate)/shares outstanding

EPS=28000*(1-0.25)*(1-0)/12000

EPS=1.75

Normal

EPS = EBIT*(1-tax rate)/shares outstanding

EPS=28000*(1-0)/12000

EPS=2.33

Expansion

EPS = EBIT*(1+Growth impact%)*(1-tax rate)/shares outstanding

EPS=28000*(1+0.12)*(1-0)/12000

EPS=2.61

a-2

%age change in EPS for Recession

=(EPS recession/EPS normal-1)*100

=(1.75/2.3333-1)*100

=-25%

%age change in EPS for Growth

=(EPS Growth/EPS normal-1)*100

=(2.6133/2.3333-1)*100

=12%

b-1

New no. of shares = old shares-debt/(Market value/old shares)

=12000-140000/(240000/12000)

=5000

EPS = (EBIT-debt*interest%)*(1-tax rate)/new shares outstanding

Recession

EPS = (EBIT*(1-recession impact%)-debt*interest %age)*(1-tax rate)/new shares outstanding

EPS=(28000*(1-0.25)-140000*0.06)*(1-0)/5000

EPS=2.52

Normal

EPS = (EBIT-debt*interest%)*(1-tax rate)/new shares outstanding

EPS=(28000-140000*0.06)*(1-0)/5000

EPS=3.92

Expansion

EPS = (EBIT*(1+growth impact%)-debt*interest %age)*(1-tax rate)/new shares outstanding

EPS=(28000*(1+0.12)-140000*0.06)*(1-0)/5000

EPS=4.59

b-2

%age change in EPS for Recession

=(EPS recession/EPS normal-1)*100

=(2.52/3.92-1)*100

=-36%

%age change in EPS for Growth

=(EPS Growth/EPS normal-1)*100

=(4.592/3.92-1)*100

=17%