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 $36,000 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 25 percent lower. The firm is considering a debt issue of $155,000 with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 6,000 shares outstanding. The firm has a tax rate 35 percent. Assume the stock price remains 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. 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

Normal:

EBIT = $36,000

Recession:

EBIT = $36,000 - 25% * $36,000
EBIT = $27,000

Expansion:

EBIT = $36,000 + 20% * $36,000
EBIT = $43,200

Answer a-1.

Total Value = $240,000
Number of shares outstanding = 6,000

Price per share = Total Value / Number of shares outstanding
Price per share = $240,000 / 6,000
Price per share = $40.00

Answer a-2.

If economy expand:

Percentage Change in EPS = ($4.68 - $3.90) / $3.90
Percentage Change in EPS = 20%

If economy collapse:

Percentage Change in EPS = ($2.93 - $3.90) / $3.90
Percentage Change in EPS = -25%

Answer b-1.

Value of Debt = $155,000

Interest Expense = 6% * $155,000
Interest Expense = $9,300

Value of Equity = $85,000
Price per share = $40.00

Number of shares outstanding = $85,000 / $40.00
Number of shares outstanding = 2,125

Answer b-2.

If economy expand:

Percentage Change in EPS = ($10.37 - $8.17) / $8.17
Percentage Change in EPS = 26.93%

If economy collapse:

Percentage Change in EPS = ($5.41 - $8.17) / $8.17
Percentage Change in EPS = -33.78%