Question

Sunrise, Inc., has no debt outstanding and a total market value of $150,000. Earnings before interest and taxes, EBIT, are projected to be $11,000 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 25 percent lower. The company is considering a $60,000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 10,000 shares outstanding. Ignore taxes for this problem. Assume the stock price is constant under all scenarios. 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.) 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 and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)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.) 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 and enter your answers as a percent rounded to 2 de cimal places, e.g., 32.16.)

Answer 1

Normal:

EBIT = $11,000

Recession:

EBIT = $11,000 - 25% * $11,000
EBIT = $8,250

Expansion:

EBIT = $11,000 + 20% * $11,000
EBIT = $13,200

Answer a-1.

Total Value = $150,000
Number of shares outstanding = 10,000

Price per share = Total Value / Number of shares outstanding
Price per share = $150,000 / 10,000
Price per share = $15.00

Answer a-2.

If economy expand:

Percentage Change in EPS = ($1.32 - $1.10) / $1.10
Percentage Change in EPS = 20.00%

If economy collapse:

Percentage Change in EPS = ($0.83 - $1.10) / $1.10
Percentage Change in EPS = -24.55%

Answer b-1.

Value of Debt = $60,000

Interest Expense = 7% * $60,000
Interest Expense = $4,200

Value of Equity = $90,000
Price per share = $15.00

Number of shares outstanding = $90,000 / $15.00
Number of shares outstanding = 6,000

Answer b-2.

If economy expand:

Percentage Change in EPS = ($1.50 - $1.13) / $1.13
Percentage Change in EPS = 32.74%

If economy collapse:

Percentage Change in EPS = ($0.68 - $1.13) / $1.13
Percentage Change in EPS = -39.82%