Question

Music City, 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. The company 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. The company has a tax rate 35 percent. Assume the stock price is constant.

  

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

  

Percentage changes in EPS
Recession	%
Expansion	%

Answer 1

a-1 Calculate earnings per share (EPS) under each of the three economic scenarios before any debt is issued.

	EPS
Recesson	1.13
normal	1.52
Expansion	1.70

a-2 Calculate the percentage changes in EPS when the economy expands or enters a recession

	% Change in EPS
Recesson	-25%
Expansion	+12%

Explanation of above

The EPS is the net income divided by 12000 of share outstanding

	Recession	Normal	Expansion
EBIT	21000	28000	31360
Interest	0	0	0
NI	21000	28000	31360
tax @ 35%	7350	9800	10976
N	13650	18200	20384
EPS	1.13	1.52	1.70
% EPS	-25%	0	+12%

b-1 Calculate earnings per share (EPS) under each of the three economic scenarios assuming the company goes through with recapitalization

	EPS
Recesson	0.68
normal	1.06
Expansion	1.24

b-2 Given the recapitalization, calculate the percentage changes in EPS when the economy expands or enters a recession

	% of change in EPS
Recesson	-35.85
Expansion	+16.98

Explanation for part b

if company goes for expansion .

Share price = Equity / shares outstanding

=$ 240000/12000

=$ 20

shares repurchased = Debt issued / share price

= $140000/20

= 7000

Interest for each year = 140000*.06 = $8400

Explanation of above

The EPS is the net income divided by 12000 of share outstanding

	Recession	Normal	Expansion
EBIT	21000	28000	31360
Interest	8400	8400	8400
NI	12600	19600	22960
Tax at 35	4410	6860	8036
N	8190	12740	14924
EPS	0.68	1.06	1.24
% EPS	-35.85	0	+16.98