Question

Sunrise, Inc., has no debt outstanding and a total market value of $230,400. Earnings before interest and taxes, EBIT, are projected to be $39,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 13 percent higher. If there is a recession, then EBIT will be 24 percent lower. The company is considering a $125,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 7,200 shares outstanding. The company has a tax rate of 22 percent, a market-to-book ratio of 1.0, and 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.) 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 decimal places, e.g., 32.16.)

Answer 1

Answer : a-1) Calculation of EPS under each economic scenerios :

Below is the table showing calculation of EPS :

EPS = Earning Available for equity shareholder's / Number of equity shares outstanding

	Normal	Expansion	Recession
EBIT	39000	44070 (39000 * 1.13)	29640 (39000 * 0.76)
Number of shares outstanding	7200	7200	7200
EPS	5.4166667 or 5.42	6.120833 or 6.12	4.11666667 or 4.12

a-2) Calculation of percentage change in EPS :

% change in EPS from Normal to expansion = (6.120833 - 5.41666667) / 5.4166667 = 13%

% change in EPS from Normal to recession = (4.1166667 - 5.41666667) / 5.4166667 = (-24)%

b-1) Calculation of EPS in case of recapitalization:

Before calculating EPS we need to calculate that after raising debt the nuber of shares repurchased :

Number of shares repurchased = Debt Value / Price per share

Price per share = Market value / Number of shres outstanding

= 230400 / 7200

= 32

Number of shares repurchased = 125000 / 32

= 3906.25

Number of shres outstanding after repurchase = 7200 - 3906.25

= 3293.75

Below is the table showing calculation of EPS :

EPS = Earning Available for equity shareholder's / Number of equity shares outstanding

	Normal	Expansion	Recession
EBIT	39000	44070 (39000 * 1.13)	29640 (39000 * 0.76)
Interest Expense ( Debt * Interest rate)	-7500	-7500	-7500
Earnings available for equity shareholder	31500	36570	22140
Number of shares outstanding	3293.75	3293.75	3293.75
EPS	9.56356736242 or 9.56	11.1028462998 or 11.10	6.72182163187 or 6.72

b-2) Calculation of percentage change in EPS :

% change in EPS from Normal to expansion = (11.1028462998 - 9.56356736242) / 9.56356736242 = 16.10%

% change in EPS from Normal to recession =(6.72182163187 - 9.56356736242) / 9.56356736242 = (-29.71%)