Question

Ghost, Inc., has no debt outstanding and a total market value of $250,000. 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 20 percent higher. If there is a recession, then EBIT will be 20 percent lower. The company is considering a $105,000 debt issue with an interest rate of 4 percent. The proceeds will be used to repurchase shares of stock. There are currently 10,000 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.)

Answer 1

Solution:
a-1.		EPS
	Recession	3.20
	Normal	4.00
	Expansion	4.80
Working Notes:
		Recession	Normal	Expansion
a	EBIT	32,000	40,000	48,000
		[40,000 x (1-0.20)]		[40,000 x (1 + 0.20)]
	÷
b	No of shares	10,000	10,000	10,000
c=a/b	EPS	3.20	4.00	4.80
	Change is EPS %	-20%	0	20%
	[new-normal)/normal]	[(3.20 - 4)/4]		[(4.80 - 4)/4]
a-2.		Percentage changes in EPS
	Recession	-20.00	%
	Expansion	20.00	%
Notes:	See above working notes:
b-1.		EPS
	Recession	4.79
	Normal	6.17
	Expansion	7.55
Working Notes:
	As per the given condition if it goes for recapitalization
	Its will raised debt and used them to repurchase share and interest on debt , by this no of shares will decrease and net income available to equity shareholders will also decrease by interest expense, as there is not taxes we will not tax benefit on interest expenses.
	Share price per share = Market value / no of shares outstanding
	Share price per share = $250,000 /10,000
	Share price per share = $25
	Amount raised as debt = $105,000
	Interest expense = Debt x interest rate
	Interest expense = $105,000 x 4%
	Interest expense = $4,200
	No of shares repurchased = Amount raised / Share price per share
	No of shares repurchased = $105,000 / $25
	No of shares repurchased = 4200
	Now the new no shares = 10,000- 4200=5,800 shares
		Recession	Normal	Expansion
	EBIT	32,000	40,000	48,000
		[40,000 x (1-0.20)]		[40,000 x (1 + 0.20)]
	Less: Interest Expense	4,200	4,200	4,200
a	Net income for Equity shareholders	27,800	35,800	43,800
	÷
b	New No of shares	5,800	5,800	5,800
c=a/b	EPS	4.793103	6.172414	7.551724
	Change is EPS %	-22.35%	0.00%	22.35%
	[new-normal)/normal]	[(4.793103 - 6.172414)/6.172414]		[(7.551724 - 6.172414)/7.551724]
4.		Percentage changes in EPS
	Recession	-22.35	%
	Expansion	22.35	%
Notes:	See above working note of 3.
Please feel free to ask if anything about above solution in comment section of the question.