Question

RAK, 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 12 percent higher. If there is a recession, then EBIT will be 25 percent lower. RAK is considering a $140,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 12,000 shares outstanding. RAK has a tax rate of 35 percent.

  

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. (Negative amounts 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	%

  

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. (Negative amounts 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

Given Data about RAK Inc.:

Total Market Value = $ 240000

EBIT in normal economy scenario = $ 28000

EBIT in strong expansion is 12% higher = $ 28000 (1.12)

= $ 31360

EBIT in recession scenario is 25% lower = $ 28000 (.75)

= $ 21000

Since there is no debt outstanding, therefore there will be no interest expense

Hence EBIT( 1-Tax Rate) = Net Operating after Tax( NOPAT) = Net income

EBIT(1- Tax Rate)= $ 28000(1-0.35)= $ 28000(0.65)= $ 18200

a 1)

In normal case scenario

EPS= Net income/ number of shares otstansding

EPS= $ 18200 / 12000 = 1.52

In strong expansion scenario

Net Income= $ 31360( 1- 0.35) = $ 20384

EPS = $ 20384 / 12000 = 1.70

In recession case scenario

Net Income = $ 21000(1-0.35)= $ 13650

EPS = 13650/12000 = 1.14

	EPS
Recession	1.14 $
Normal	1,52 $
Expansion	1.70 $

a-2)

% change in EPS during recession= [( $1.14- $1.52) / $1.52] * 100

= -25%

% change in EPS during strong economy= [ ( $ 1.70 - $ 1.52) / 1.52] * 100

= 11.84 %

	percentage change in EPS
Recession	-25 %
Expansion	11.84%

b-1)

Price of the share= Market Value/ Number of shares oustanding

= $ 240000 / 12000

= $ 20

Shares that can be bought back by debt of $ 140000 is = $ 140000 / $ 20

= 7000

Therefore EPS after recapitalization in normal case scenario= (Total earnings - after tax cost of funds) / (shares outstanding after buyback)

= ( $ 28000 - 7000 shares * $ 20 * 0.06) / (12000-7000)

= $ 19600 / 5000

= $ 3.92

In expansion case scenario EPS after recapitalization = ( $ 31360 - 7000 shares * $ 20 * 0.06) / (12000-7000)

= $ 22960 / 5000

= $4.59

In recession case scenario EPS after recapitalization = ( $ 21000 - 7000 shares * $ 20 * 0.06) / (12000-7000)

= $ 12600 / 5000

= $ 2.52

	EPS
Recession	2.52 $
Normal	3.92 $
Expansion	4.59 $

  

b-2)

% Change in EPS during Recession = [($ 2.52 - $ 3.92) / $ 3.92] * 100

= -35.71 %

% Change in EPS during Expansion = [($ 4.59 - $ 3.92) / $ 3.92] * 100

= 17.09 %

	Percentage change in EPS
Recession	-35.71 %
Expansion	17.09 %