Question

Ghost, Inc., has no debt outstanding and a total market value of $220,000. Earnings before interest and taxes, EBIT, are projected to be $40,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 10 percent higher. If there is a recession, then EBIT will be 20 percent lower. The company is considering a $135,000 debt issue with an interest rate of 4 percent. The proceeds will be used to repurchase shares of stock. There are currently 11,000 shares outstanding. Ignore taxes for this problem. 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.) Recession EPS Normal EPS Expansion EPS Recession percentage change in EPS Expansion percentage change in EPS Recession EPS Normal EPS Expansion EPS Recession percentage change in EPS Expansion percentage change in EPS

Answer 1

a-1

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

Recession

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

EPS=40000*(1-0.2)*(1-0)/11000

EPS=2.91

Normal

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

EPS=40000*(1-0)/11000

EPS=3.64

Expansion

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

EPS=40000*(1+0.1)*(1-0)/11000

EPS=4

a-2

%age change in EPS for Recession

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

=(2.9091/3.6364-1)*100

=-20%

%age change in EPS for Growth

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

=(4/3.6364-1)*100

=10%

b-1

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

=11000-135000/(220000/11000)

=4250

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=(40000*(1-0.2)-135000*0.04)*(1-0)/4250

EPS=6.26

Normal

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

EPS=(40000-135000*0.04)*(1-0)/4250

EPS=8.14

Expansion

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

EPS=(40000*(1+0.1)-135000*0.04)*(1-0)/4250

EPS=9.08

b-2

%age change in EPS for Recession

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

=(6.2588/8.1412-1)*100

=-23%

%age change in EPS for Growth

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

=(9.0824/8.1412-1)*100

=12%