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.)

  

	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	%
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.)

  

	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

For a-1 & a-2, refer below screen shot-

EPS = NI/(number of shares outstanding) = (EBIT-Tax)/(number of shares outstanding)

*No debt was considered for the above analysis as indicated in question.

For b-1 & b-2, refer below screen shot-

Debt of $66,000 will be issued. This amount will be used for shares repurchase.

Stock Price = MarketCapitalization / (number of shares outstanding)

=220,000/10,000=$22

Number of stocks that company will repurchase by using 66,000 = 66,000/22 = 3,000

Number of shares outstanding after repurchase = 10,000 - 3,000 = 7,000

{We assume that Market Value will remain $220,000 under all market conditions}