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 $42,000 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 30 percent lower. RAK is considering a $66,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 10,000 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.)

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.)

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.)

?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.)

Recession: %

?Expansion:    %

Answer 1

Earnings per share (EPS) Calculation:

Total market value	$220,000
Earnings before interest and taxes (EBIT)	$42,000
Expansion, then EBIT	20% higher than normal
Recession, then EBIT	30% lower than normal
Shares outstanding	10000
Tax rate	35%
	Recession	Normal	?Expansion
EBIT	$29,400	$42,000	$50,400
Interest	$0	$0	$0
Earning after Interest	$29,400	$42,000	$50,400
Taxes (35% of earning after interest)	$10,290	$14,700	$17,640
Net Income (Earning after Interest - taxes)	$19,110	$27,300	$32,760
Number of Shares outstanding	10,000	10,000	10,000
EPS (Net Income/Number of Shares outstanding)	$1.91	$2.73	$3.28
% change in EPS	-30.00%		20.00%

Therefore,

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

Recession:    $1.91

Normal: $2.73

?Expansion: $3.28

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

Recession:   -30%

Expansion:    20%

?b-1.

Share price = Market value of company without debt / Number of Shares outstanding

Share price = $220,000 / 10,000

Share price = $22 per share

If the company will go under the proposed recapitalization

Shares repurchased = Value Debt issued / Share price

Shares repurchased = $66,000 / $22

Shares repurchased = 3,000

Therefore remaining number of shares outstanding after debt issued = 10,000 – 3,000 = 7,000

Total market value	$220,000
Earnings before interest and taxes (EBIT)	$42,000
Expansion, then EBIT	20% higher than normal
Recession, then EBIT	30% lower than normal
Value of Debt issued	$66,000
Interest rate	6%
Interest on Debt (6% *$66,000)	$3,960
Shares outstanding after repurchase	7000
Tax rate	35%
	Recession	Normal	?Expansion
EBIT	$29,400	$42,000	$50,400
Interest	$3,960	$3,960	$3,960
Earning after Interest	$25,440	$38,040	$46,440
Taxes (35% of earning after interest)	$8,904	$13,314	$16,254
Net Income (Earning after Interest - taxes)	$16,536	$24,726	$30,186
Number of Shares outstanding	7,000	7,000	7,000
EPS (Net Income/Number of Shares outstanding)	$2.36	$3.53	$4.31
% change in EPS	-33.12%		22.08%

Now calculate earnings per share (EPS) under each of the three economic scenarios assuming the company goes through with recapitalization.

?Recession: $2.36

Normal: $3.53

?Expansion: $4.31

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

Recession: -33.12%

?Expansion:   22.08%