Question

Beckett, Inc., has no debt outstanding and a total market value of $250,000. 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 18 percent higher. If there is a recession, then EBIT will be 30 percent lower. Beckett is considering a debt issue of $100,000 with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 10,000 shares outstanding. The company 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 final 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. (Do not round intermediate calculations. Negative amounts should be indicated by a minus sign. Enter your answers as a percent.)

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 final 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

Formulae that we have considered

t=tax rate

A-1

A2

Recession % change

  

=-30%

Expansion % change

=18%

Comment: In the absence of debt EPS changes by the % that EBIT changes

B1

B2

Recession % change

  

=-37.062%

Expansion % change

=22.237%

Comment: Changes In EPS increase (Quantitively) in the presence of debt.