Question

ebit and leverage ghost inc., has no debt oustanding and a total market value of $185,000 Earnings before interest and taxes, EBIT are projected to be $29000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 30 percent higher. If there is a recession , then EBIT will be 40 percent lower. The company is considering a $65000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock . There are currently 7400 shares outstanding. Ignore taxes for this problem.
a) Calculate earnings per share (EPS) under each of the three economic scenarious before any debt is issued
b) Calculate the percentage changes in EPS when the ecnonomy expands or enters a recession
c) Repeat part (a) assuming that the company goes through with recapitalization. What do you observe?
Please do not not do in excel or word. Show full formula.

Answer 1

a) Earnings per share (EPS) under each of the three economic scenarious before any debt is issued

	Normal	Expansion	Recession
EBIT ($)	29,000	37,700	17,600
Number of shares	7,400	7,400	7,400
EPS = EBIT/Number of shares	$3.92	$5.09	$2.38

b) % increase in EPS when economy expands = (EPS after expansion - EPS before expansion)/EPS before expansion

= (5.09 - 3.92)/3.92

= 29.85%

% decrease in EPS when economy goes into recession = (EPS before recession - EPS after recession)/EPS before recession

= (3.92 - 2.38)/3.92

= 39.29%

c)

Interest on debt = Debt x Interest %

= 65,000 x 7%

= $4,550

The proceeds from debt will be used to repurchase shares of stock

Market price of 1 share = Total market value of shares/Number of shares

= 185,000/7,400

= $25

Number of shares bought back = Debt proceeds/Market price of 1 share

= 65,000/25

= 2,600

Hence, number of shares outstanding after debt issue = Total shares outstanding - Number of shares bought back

= 7,400 - 2,600

= 4,800

Earnings per share (EPS) under each of the three economic scenarious after debt is issued

	Normal	Expansion	Recession
EBIT ($)	29,000	37,700	17,600
Less: Interest on debt	- 4,550	- 4,550	- 4,550
Earnings after interest	24,450	33,150	13,050
Number of shares	4,800	4,800	4,800
EPS = Earnings after interest/Number of shares	$5.09	$6.91	$2.72

After debt issue, EPS has increased in all the situations.

Exact answers may slightly differ due to rounding off.