Question

Music City, Inc., has no debt outstanding and a total market value of $150,000. Earnings before interest and taxes, EBIT, are projected to be $36,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 15 percent higher. If there is a recession, then EBIT will be 25 percent lower. The company is considering a $95,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 6,000 shares outstanding. Ignore taxes for this problem. Assume the stock price is 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 and 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 and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

  

Percentage changes in EPS
Recession	%
Expansion	%

Answer 1

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a1.
		Recession	Normal	Expansion
EBIT		27000	36000	41400
Interest		0	0	0
Net Income		27000	36000	41400
Shares outstanding		6000	6000	6000
Earning per share		4.5	6	6.9
a2.
		Recession	Normal	Expansion
Earning per share		4.5	6	6.9
Change		(4.5-6)/6		(6.9-6)/6
		-25%		15%
b1.
		Recession	Normal	Expansion
EBIT		27000	36000	41400
Interest 95000*8%		7600	7600	7600
Net Income		19400	28400	33800
Shares outstanding		2200	2200	2200
Earning per share		8.82	12.91	15.36
Working:
Market Value	150000
No of shares	6000
Per Share price	150000/6000	25
Share to be purchased	95000/25	3800
Balance Share	6000-3800	2200
b2.
		Recession	Normal	Expansion
Earning per share		8.82	12.91	15.36
Change		(8.82-12.91)/12.91		(15.36-12.91)/12.91
		-31.68%		18.98%