Question

Minion, Inc., has no debt outstanding and a total market value of $200,000. Earnings before interest and taxes, EBIT, are projected to be $30,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 18 percent higher. If there is a recession, then EBIT will be 20 percent lower. The company is considering a $75,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 8,000 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

a-1

EPS = EBIT*(1-tax rate)/shares outstanding

Recession

EPS = EBIT*(1-recession impact%)*(1-tax rate)/shares outstanding

EPS=30000*(1-0.2)*(1-0)/8000

EPS=3

Normal

EPS = EBIT*(1-tax rate)/shares outstanding

EPS=30000*(1-0)/8000

EPS=3.75

Expansion

EPS = EBIT*(1+Growth impact%)*(1-tax rate)/shares outstanding

EPS=30000*(1+0.18)*(1-0)/8000

EPS=4.43

a-2

%age change in EPS for Recession

=(EPS recession/EPS normal-1)*100

=(3/3.75-1)*100

=-20%

%age change in EPS for Growth

=(EPS Growth/EPS normal-1)*100

=(4.425/3.75-1)*100

=18%

b-1

New no. of shares = old shares-debt/(Market value/old shares)

=8000-75000/(200000/8000)

=5000

EPS = (EBIT-debt*interest%)*(1-tax rate)/new shares outstanding

Recession

EPS = (EBIT*(1-recession impact%)-debt*interest %age)*(1-tax rate)/new shares outstanding

EPS=(30000*(1-0.2)-75000*0.08)*(1-0)/5000

EPS=3.6

Normal

EPS = (EBIT-debt*interest%)*(1-tax rate)/new shares outstanding

EPS=(30000-75000*0.08)*(1-0)/5000

EPS=4.8

Expansion

EPS = (EBIT*(1+growth impact%)-debt*interest %age)*(1-tax rate)/new shares outstanding

EPS=(30000*(1+0.18)-75000*0.08)*(1-0)/5000

EPS=5.88

b-2

%age change in EPS for Recession

=(EPS recession/EPS normal-1)*100

=(3.6/4.8-1)*100

=-25%

%age change in EPS for Growth

=(EPS Growth/EPS normal-1)*100

=(5.88/4.8-1)*100

=22.5%