Question

Castle, Inc., has no debt outstanding and a total market value of $200,000. Earnings before interest and taxes, EBIT, are projected to be $30,000 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 20 percent lower. The firm is considering a debt issue of $75,000 with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 8,000 shares outstanding. The firm 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 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. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to the nearest whole number, e.g., 32.)

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. (A negative answer 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

EBIT in normal Scenario = 30000
EBIT after Tax = 30000 * (1 - 35%) = 19,500

EBIT in recession = 30000 * (1-20%) = 24000
EBIT after Tax =24000 * (1 - 35%) = 15,600

EBIT in boom = 30000* (1+18%) = 35,400
EBIT after Tax = 35400 * (1 - 35%) = 23,010
No of shares = 8000

a-1)

EPS in recession = 15600/8000 = 1.95
EPS in Normal = 19500/8000 = 2.44
EPS in Boom = 23010/8000 = 2.88

a-2)

Percentage change in EPS when it goes into recession = (1.95-2.44)/2.44 = -20%
Percentage change in EPS when it goes into boom = (2.88-2.44)/2.44 = 18%

b-1)
earnings per share (EPS) under each of the three economic scenarios assuming the company goes through with recapitalization.
EBIT in normal Scenario = 30000
EAT= (30000 - Interest)* (1 - 35%) = (30000 - 75,000*8%))* (1 - 35%) = 15600

EBIT in recession = 30000 * ( 1-20%) = 24000
EBIT after Tax =(24000 - Interest)* (1 - 35%) = (24000 - 75,000*8%))* (1 - 35%)= 11700

EBIT in boom =30000* ( 1+18%) = 35,400
EBIT after Tax = (35400 - Interest)* (1 - 35%) = (35400 - 75,000*8%))* (1 - 35%)= 19110

b-2)
No of shares before debt issue= 8000
Price Per share = 200000/8000 = 25
No of Shares outstanding after Debt issue = 8000 - 70,000/25 = 5200

EPS in recession = 11700/5200 = 2.25
EPS in Normal =   15600/5200 = 3
EPS in Boom =   19110/5200= 3.625

Percentage change in EPS when it goes into recession = (2.25-3)/3= -25%
Percentage change in EPS when it goes into boom = (3.625-3)/3 = 20.83%

Thank you

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