Question

Kaelea, Inc., has no debt outstanding and a total market value of $165,000. Earnings before interest and taxes, EBIT, are projected to be $9,900 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 24 percent higher. If there is a recession, then EBIT will be 31 percent lower. The company is considering a $46,500 debt issue with an interest rate of 5 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,500 shares outstanding. Ignore taxes for this problem.

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.)

	ESP
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.

	% 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.

d. Calculate the percentage changes in EPS when the economy expands or enters a recession.

Answer 1

Solution:
A.		EPS
	Recession	1.24
	Normal	1.80
	Expansion	2.23
Working Notes:
Notes:	As there is no debt and taxes is to be ignored for this problem ,means we can get EPS Earnings per share by simply dividing EBIT at each scenario with total no of shares outstanding . First of all we have to compute EBIT at recession & Expansion, then at last we will get EPS
		Recession	Normal	Expansion
a	EBIT	6,831	9,900	12,276
		[9,900 x (1- 31%)]		[9,900 x (1 + 24%)]
	÷
b	No of shares	5,500	5,500	5,500
c=a/b	EPS	1.242	1.800	2.232
	Change is EPS %	-31%	0	24%
	[new-normal)/normal]	[(1.242 - 1.80)/1.80]		[(2.232 - 1.80)/1.80]
B.		Percentage changes in EPS
	Recession	-31.00	%
	Expansion	24.00	%
Notes:	See above working notes: A. above
Notes:	To get change in EPS we use formula above is (EPS at scenario - EPS at Normal)/EPS at Normal
C.		EPS
	Recession	1.14
	Normal	1.92
	Expansion	2.52
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 = $165,000 /5,500
	Share price per share = $30
	Amount raised as debt = $46,500
	Interest expense = Debt x interest rate
	Interest expense = $46,500 x 5%
	Interest expense = $2,325
	No of shares repurchased = Amount raised / Share price per share
	No of shares repurchased = $46,500 / $30
	No of shares repurchased =1,550
	Now the new no shares = 5,500- 1,550=3,950 shares
		Recession	Normal	Expansion
	EBIT	6,831	9,900	12,276
		[9,900 x (1- 31%)]		[9,900 x (1 + 24%)]
	Less: Interest Expense	2,325	2,325	2,325
a	Net income for Equity shareholders	4,506	7,575	9,951
	÷
b	New No of shares outstanding	3,950	3,950	3,950
c=a/b	EPS	1.140759	1.917722	2.519241
	Change is EPS %	-40.51%		31.37%
	[new-normal)/normal]	[(1.140759 - 1.917722)/1.917722]		[(2.519241 - 1.917722)/1.917722]
D.		Percentage changes in EPS
	Recession	-40.51	%
	Expansion	31.37	%
Notes:	See above working note of C.
Please feel free to ask if anything about above solution in comment section of the question.