Question

RAK, Inc., has no debt outstanding and a total market value of $165,000. Earnings before interest and taxes, EBIT, are projected to be $21,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT wIll be 25 percent higher. If there is a recession, then EBIT will be 35 percent lower. The company is considering a $60,000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock.There are currently 5,500 shares outstanding. Ignore taxes for this problem.

a. Calculate earnings per share, EPS, under each of the 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 the company goes through with recapitalization. What do you observe?

Answer 1

Before recapitalization:

Market Value of Assets = $165,000

Number of shares outstanding = 5,500

Current Price per share = Market Value of Assets / Number of shares outstanding
Current Price per share = $165,000 / 5,500
Current Price per share = $30

After recapitalization:

Market Value of Assets = $165,000

Debt = $60,000

Equity = Total Assets - Debt
Equity = $165,000 - $60,000
Equity = $105,000

Current Price per share = $30

Number of shares outstanding = $105,000 / $30
Number of shares outstanding = 3,500

Interest Expense = 7% * $60,000
Interest Expense = $4,200

Answer a.

Answer b.

So, Company should issue debt and repurchase shares as EPS under each scenario will increase.