Question

Castle, Inc., has no debt outstanding and a total market value of $180,000. Earnings before interest and taxes, EBIT, are projected to be $25,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 10 percent higher. If there is a recession, then EBIT will be 20 percent lower. The firm is considering a $60,000 debt issue with an interest rate of 5 percent. The proceeds will be used to repurchase shares of stock. There are currently 6,000 shares outstanding. Ignore taxes for this problem.

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 capitalization. (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 the nearest whole number e.g., 32.)

	PERCENTAGE CHANGES IN EPS
Recession	%
Expansion	%

Answer 1

Normal:

EBIT = $25,000

Recession:

EBIT = $25,000 - 20% * $25,000
EBIT = $20,000

Expansion:

EBIT = $25,000 + 10% * $25,000
EBIT = $27,500

Answer a-1.

Total Value = $180,000
Number of shares outstanding = 6,000

Price per share = Total Value / Number of shares outstanding
Price per share = $180,000 / 6,000
Price per share = $30.00

Answer a-2.

If economy expand:

Percentage Change in EPS = ($4.58 - $4.17) / $4.17
Percentage Change in EPS = 10%

If economy collapse:

Percentage Change in EPS = ($3.33 - $4.17) / $4.17
Percentage Change in EPS = -20%

Answer b-1.

Value of Debt = $60,000

Interest Expense = 5% * $60,000
Interest Expense = $3,000

Value of Equity = $120,000
Price per share = $30.00

Number of shares outstanding = $120,000 / $30.00
Number of shares outstanding = 4,000

Answer b-2.

If economy expand:

Percentage Change in EPS = ($6.13 - $5.50) / $5.50
Percentage Change in EPS = 11%

If economy collapse:

Percentage Change in EPS = ($4.25 - $5.50) / $5.50
Percentage Change in EPS = -23%