Question

Zemfira Inc., EBIT and Leverage. (Ross #1 ch.13) Zemfira Inc., has no debt outstanding and a total market value of $125,000. Earnings before interest and taxes are projected to be $10,400 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 20 percent higher. If there is a recession, then EBIT will be 35 percent lower. Zemfira is considering a $42,000 debt issue with a 6 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 6,250 shares outstanding. Ignore taxes for part a and b. a. Calculate EPS under each of three economic scenarios before any debt is issued. Also, calculate the percentage changes in EPS when the economy expands or enters a recession. b. Repeat part (a) assuming that Zemfira goes through with recapitalization. c. Repeat parts (a) and (b) assuming Zemfira has a tax rate of 35 percent. Will the percentage change in EPS be the same both with and without taxes? d. Suppose the company has a market-to-book ratio of 1.0 i. Calculate ROE under each of three economic scenarios before any debt is issued. Also, calculate the percentage changes in ROE for economic expansion and recession, assuming no taxes. ii. Repeat part (a) assuming the firm goes through with proposed recapitalization. iii. Repeat parts (a) and (b) assuming the firm has a tax rate of 35 percent.

Answer 1

Calculation of EPS

10400/6250 =1.66 Per share

On expansion of Economy of 20 %

12480/6250 = 1.97 Per share

On recession of 35%

6760/6250 =1.08 per share

% CHANGE IN EPS

On expansion of Economy of 20 %

=1.97-1.66/1.66*100 = 18.67%

On recession of 35%

1.08-1.66/1.66*100= -34.94%

bCalculation of EPS after issue of debenture but before tax

7880/6250=1.26

On expansion of Economy of 20 %

9960/6250= 1.59

On recession of 35%

4240/6250 = 0.68

% CHANGE IN eps

On expansion of Economy of 20 %

1.59-1.26/1.26*100 =26.19%

On recession of 35%

0.68-1.26/1.26*100 = -46.03%

Calculation of EPS after tax

	current	expansion of economy @ 20 %	recession @ 35%
EBIT	10400	12480	6760
Less Interest	2520	2520	2520
EBT	7880	9960	4240
TAX@ 35%	2758	3486	1484
	5122	6475	2756
No of shares outstanding	6250	6250	6250
EPS	0.82	1.04	0.44

Changes in EPS

On expansion of Economy of 20 %

=1.04-0.82/0.82*100 = 26.83%

On recession of 35%

=0.44-0.82/0.82*100 =-46.34 %

ROE= EAT/Shareholders equity*100

=10400/125000*100 = 8.32%

On expansion of Economy of 20 %

=12480/125000*100 = 9.98%

On recession of 35%

=6760/125000*100 = 5.41%

changes in roe

On expansion of Economy of 20 %

=9.98-8.32/8.32*100 =19.95 %

On recession of 35%

5.41-8.32/8.32*100 =- 34.98%

Calculation of ROE after issue of debenture but before tax

7880/125000*100= 6.30%

On expansion of Economy of 20 %

9960/125000*100 = 7.97%

On recession of 35%

4240/125000*100 = 3.39%

changes in ROE

On expansion of Economy of 20 %

7.97-6.3/6.3*100 = 26.51%

On recession of 35%

3.39-6.3/6.3*100 = -46.19 %

Calculation of ROE After interest and tax

5122/125000*100= 4.09%

On expansion of Economy of 20 %

6475/125000*100 = 5.18%

On recession of 35%

2756/125000*100 = 2.20 %

Chnges in ROE

On expansion of Economy of 20 %

=5.18-4.09/4.09*100= 26.65%

On recession of 35%

2.20-4.09/4.09*100 = -46.21%