Question

RAK, Inc., has no debt outstanding and a total market value of $220,000. Earnings before interest and taxes, EBIT, are projected to be $40,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 10 percent higher. If there is a recession, then EBIT will be 20 percent lower. RAK is considering a $135,000 debt issue with an interest rate of 4 percent. The proceeds will be used to repurchase shares of stock. There are currently 11,000 shares outstanding. RAK has a tax rate of 35 percent.

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. (Negative amounts 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 -23.06 %

Expansion 11.53 %

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. (Negative amounts 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

A) The share price is $20, and there are 11,000 shares outstanding. The last row shows thepercentage change in EPS the company will experience in a recession or an expansion economy.

Recession Normal Expansion

EBIT $32,000 $40,000 $44,000

Interest 0 0 0

Taxes 11,200 14,000 15,400

NI $20,800 $26,000 $28,600

1. EPS $1.89 $2.36 $2.60

2. %?EPS –20 — +10

b.If the company undergoes the proposed recapitalization, it will repurchase:

Share price = Equity / Shares outstanding

Share price = $220,000 / 11,000

Share price = $20

Shares repurchased = Debt issued / Share price

Shares repurchased = $135,000 / $20

Shares repurchased = 6,750

The interest payment each year under all three scenarios will be:

Interest payment = $135,000(.04) = $5,400

The last row shows the percentage change in EPS the company will experience in a recession or an expansion economy under the proposed recapitalization.

Recession Normal Expansion

EBIT $32,000 $40,000 $44,000

Interest 5,400 5,400 5,400

Taxes 9,310 12,110 13,510

NI $17,290 $22,490 $25,090

1. EPS $4.07 $5.29 $5.90

2. %?EPS – 23.12 — + 11.56