Question

Pendergast, Inc., has no debt outstanding and a total market value of $180,000. Earnings before interest and taxes, EBIT, are projected to be $23,000 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 30 percent lower. Pendergast is considering a $75,000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 6,000 shares outstanding. Pendergast has a tax rate of 35 percent.

A-1 Calculate the earning per share EPS under each of the three economic scenarios before any debt is issued. (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. (Negative amounts should be indicated by a minus sign.)

Percentage changes in EPS
Recession	%
Expansion	%

B-1 Assume that the company goes through with recapitalization. Calculate earnings per share (EPS ) under each of the three economic scenarios assuming the company goes through with the recapitalization.

	EPS
Recession	$
Normal	$
Expansion	$

B-2 Given the recapitalization calculate the percentage changes in EPS when the economy expands of enters a recession.

Percentage Changes in EPS
Recession	%
Expansion	%

Answer 1

Answer to A-1

Recession	$23000*.7*(1-.35)/6000	$1.744
Normal	$23000*(1-.35)/6000	$2.4917
Expansion	$23000*1.2*(1-.35)/6000	$2.99

Answer to A-2        

Recession	(2.4917-1.744)/2.4917	-30%
Expansion	(2.99-2.4917)/2.4917	20%

Answer to B-1

Loan taken = $75,000

Current price of per share = $180000/6000 = $30

Repurchase of share = $75000/$30 = 2500 Shares

No of shares after repurchase = 6000 -2500 = 3500

Interest on loan = $75000*7% = $5,250

Net Income in Normal Case =$23000- $5250 = $17750*(1-.35) = $11537.5

Net Income in Expansion Case =$23000*1.2 - $5250 = $22350 *(1-.35) = $14527.5

Net Income in Recession Case =$23000*.7 - $5250 = $10850 *(1-.35)= $7052.5

Recession	$7052.5/3500	$2.015
Normal	$11537.5/3500	$3.296
Expansion	$14527.5/3500	$4.1507

         

Answer to B-2

Recession	(3.296-2.015)/3.296	-38.86%
Expansion	(4.1507-3.296)/3.296	25.93%

                                   

  Thanks