Question

Sunrise, Inc., has no debt outstanding and a total market value of $296,400. Earnings before interest and taxes, EBIT, are projected to be $45,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 19 percent higher. If there is a recession, then EBIT will be 30 percent lower. The company is considering a $155,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 7,800 shares outstanding. The company has a tax rate of 23 percent, a market-to-book ratio of 1.0, and 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.)
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

Normal:

EBIT = $45,000

Recession:

EBIT = $45,000 - 30% * $45,000
EBIT = $31,500

Expansion:

EBIT = $45,000 + 19% * $45,000
EBIT = $53,550

Answer a-1.

Total Value = $296,400
Number of shares outstanding = 7,800

Price per share = Total Value / Number of shares outstanding
Price per share = $296,400 / 7,800
Price per share = $38.00

Answer a-2.

If economy expand:

Percentage Change in EPS = ($5.29 - $4.44) / $4.44
Percentage Change in EPS = 19.14%

If economy collapse:

Percentage Change in EPS = ($3.11 - $4.44) / $4.44
Percentage Change in EPS = -29.95%

Answer b-1.

Value of Debt = $155,000

Interest Expense = 8% * $155,000
Interest Expense = $12,400

Value of Equity = $141,400
Price per share = $38.00

Number of shares outstanding = $141,400 / $38.00
Number of shares outstanding = 3,721

Answer b-2.

If economy expand:

Percentage Change in EPS = ($8.52 - $6.75) / $6.75
Percentage Change in EPS = 26.22%

If economy collapse:

Percentage Change in EPS = ($3.95 - $6.75) / $6.75
Percentage Change in EPS = -41.48%