Question

Castle, 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 10 percent higher. If there is a recession, then EBIT will be 25 percent lower. The firm is considering a debt issue of $48,000 with an interest rate of 4 percent. The proceeds will be used to repurchase shares of stock. There are currently 20,000 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.)

	EPS
Recession	$
Normal	$
Expansion	$

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. Enter your answers as a percent rounded to the nearest whole number, e.g., 32.)

Percentage changes in EPS
Recession	%
Expansion	%

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.)

		EPS
Recession	$
Normal	$
Expansion	$

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. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

Percentage changes in EPS
Recession	%
Expansion	%

Answer 1

• Calculation of EPS under each of three economic scenarios before any Debt is issued. (A-1)

EPS = Earnings available for equity shareholders(EAE) / Number of shares outstanding

EAE = EBIT - Interest - Tax - Preference Dividend

Since in this part there is no debt outstanding, there will be no interest and Taxation is to be ignored in this question. So, EAE = EBIT.

Computation of EPS

Particulars	Recession	Normal	Expansion
EAE (EBIT)	25% lower than Normal EBIT = 75% of $28,000 = $21,000	$28,000	10% higher than Normal EBIT = 110% of $28,000 = $30,800
Number of shares outstanding	20,000	20,000	20,000
EPS	$1.05	$1.4	$1.54

• Percentage changes in EPS when the economy expands or enters a recession. (A-2)

Percentage Change In EPS = (EPS under changed conditions / EPS under normal conditions) * 100

So during expansion, EPS increases by 10%.

So during Recession, EPS decreases by 25%.

Percentage Change in EPS

Expansion	10%
Recession	- 25%

• EPS under each of the three economic scenarios assuming the company goes through with recapitalization. (B-1)

EPS = Earnings available for equity shareholders(EAE) / Number of shares outstanding

EAE = EBIT - Interest - Tax - Preference Dividend

Now the firm is considering a debt issue of $48,000 whose proceeds will be used to repurchase shares of stock as a result of it total number of shares outstanding will be reduced by Shares repurchased by the company at current market price.

Current Market Price = Market Value / Number of shares outstanding before repurchase

  

Number of Shares Repurchased = Debt Issue Amount / Current Market Price

Number of shares outstanding after repurchase = Shares outstanding before repurchase - Shares Repurchased

= 20,000 - 4,000

= 16,000 shares

Computation of EPS

Particulars	Recession	Normal	Expansion
EBIT	$21,000	$28,000	$30,800
Less : Interest on Debt	(4% of $48,000) = ($1,920)	(4% of $48,000) = ($1,920)	(4% of $48,000) = ($1,920)
EAE	$19,080	$26,080	$28,880
Number of shares outstanding	16,000	16,000	16,000
EPS	$1.19	$1.63	$1.81

• Percentage changes in EPS when the economy expands or enters a recession after Recapitalization . (B-2)

Percentage Change In EPS = (EPS under changed conditions / EPS under normal conditions) * 100

So after expansion, EPS increases by 11.04%.

So after Recession, EPS decreases by 27%.

Percentage Change in EPS

Expansion	11.04%
Recession	- 27%