Question

1. Michaels is a levered firm with $55,000 of debt. Michaels pays tax at the rate of 30%. The firm faces EBIT scenarios of recession, normal, and boom. {Note: EBIT = earnings before interest and tax, $ Interest = dollar amount of interest owed on the debt, NIBT = net income before tax, NI = net income, EPS = earnings per share}. Assume that firms with zero or negative NIBT pay zero in tax. ………………………..EBIT………..$ INTEREST…….. NIBT…………TAXES……… NI…….EPS  ----------------------------------------------------------------------------------- BOOM ………….$9,000………….$4,400  NORMAL………………………………….....………………. $1,137  RECESSION…….$2,000……………………………………………………………………………........-$6.00 What coupon interest rate does Michaels pay on its debt?

	a.	5%
	b.	6%
	c.	7%
	d.	9%
	e.	8%

2. Michaels is a levered firm with $55,000 of debt. Michaels pays tax at the rate of 30%. The firm faces EBIT scenarios of recession, normal, and boom. {Note: EBIT = earnings before interest and tax, $ Interest = dollar amount of interest owed on the debt, NIBT = net income before tax, NI = net income, EPS = earnings per share}. Assume that firms with zero or negative NIBT pay zero in tax. ………………………..EBIT………..$ INTEREST…….. NIBT…………TAXES……… NI…….EPS  ----------------------------------------------------------------------------------- BOOM ………….$9,000………….$4,400  NORMAL…………......………………………………………. $1,137  RECESSION…….$2,000……………………………………………………………………………..........-$6.00 What amount comes closest to Michaels EPS in the BOOM scenario?

	a.	$2.44
	b.	$4.11
	c.	$0.57
	d.	$5.32
	e.	$8.05

Answer 1

1.

Calculate the coupon interest rate:

Debt amount = $ 55,000

Coupon interest = $4,400

Coupon rate = (Coupon interest * 100)/Debt Amount

                     = $4,400 *100 / $ 55,000

                     = 8%

Hence, coupon interest rate is 8%. Therefore, option e is correct and remaining options are incorrect.

2.

Calculate the earnings per share (EPS):

Net income is required to calculate earnings per share. Hence, net income should be calculated first.

Net income = Earnings before interest and income tax (EBIT) - Interest

Therefore, net income (NI) is $3,220

Number of shares are not given. It can be calculated using recession information.

Let number of shares be x.

In recession scenario, EPS = -$ 6

Revenue in recession scenario = $2,000

Interest paid is same for scenarios. Hence, given interest paid in Boom is equal to interest paid in recession.

Interest paid = $4,400

Net income/(loss) = Revenue - Interest

                             = $2,000 - $4,400

                             = - $2,400

EPS = Net Income or loss/Number of shares

-$ 6 = -$2,400/x

-6x = -2,400

x = -2,400/-6

x = 400 shares

Therefore, number of shares are 400 shares.

Earnings per share is calculated by dividing the net income with common stock.

Earnings per share (EPS) = Net Income/Number of shares of Common stock

                                         = $3,220 /400

                                         = $8.05

Therefore, option e is correct and remaining options are incorrect.