Question

Kaelea, Inc., has no debt outstanding and a total market value of $100,000. Earnings before interest and taxes, EBIT, are projected to be $8,400 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 $35,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 4,000 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.)

	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. (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.)

	%ΔEPS
Recession	%
Expansion	%

rev: 04_20_2017_QC_CS-86652

Answer 1

a. Calculation of EPS in each of three scenarios

EPS = Net income / number of shares outstanding

	Normal	Recession	Expansion
EBIT	$8,400	$8400 – 31% = $5,796	$8400 +24% = $10,416
Number of shares	4,000	4,000	4,000
EPS	$8400 / 4000 = $2.10	$5,796 / 4000 = $1.44	$10,416 / 4000 = $2.60

b. Calculation of percentage change in EPS due to recession and expansion

EPS under normal condition - $2.10

EPS under recession - $1.44

Difference = $2.1 - $1.44 = (-) $0.66

% change in EPS in recession = 0.66/ 2.10 * 100

                                             = (-) 31%

EPS under normal condition - $2.10

EPS under expansion - $2.60

Difference = $2.1 - $2.6 = $0.50

% change in EPS in recession = 0.50/ 2.10 * 100

                                             = 24%

c. Calculation of EPS after debt issue in each of the condition.

	Normal	Recession	Expansion
EBIT   (A)	$8,400	$8400 – 31% = $5,796	$8400 +24% = $10,416
Interest $35000 * 6% (B)	$2,100	$2,100	$2,100
Net Income (C = A-B)	$6,300	$3,696	$8316
Number of shares	4,000	4,000	4,000
EPS	$6,300 / 4000 = $1.57	$3,696 / 4000 = $0.92	$8,316 / 4000 = $2.07

d. Calculation of percentage change in EPS due to recession and expansion

              

EPS under normal condition - $1.57

EPS under recession - $0.92

Difference = $1.57 - $0.92 = (-) $0.65

% change in EPS in recession = $0.65/ $1.57 * 100

                                             = (-) 41.20%

EPS under normal condition - $1.57

EPS under expansion - $2.07

Difference = $1.57 - $2.07 = $0.50

% change in EPS in recession = 0.50/ 1.57 * 100

                                             = 31.84 %