Question

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RAK, Inc., has no debt outstanding and a total market value of $200,000. Earnings before interest...

RAK, Inc., has no debt outstanding and a total market value of $200,000. Earnings before interest and taxes, EBIT, are projected to be $26,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 12 percent higher. If there is a recession, then EBIT will be 25 percent lower. RAK is considering a $65,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 10,000 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. (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

  

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. (Leave no cells blank - be certain to enter "0" wherever required. 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. (Negative amounts should be indicated by a minus sign. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

  

Percentage changes in EPS
  Recession %
  Expansion %

Solutions

Expert Solution

Given,
Market Value of RAK Inc = $200000
No of Shares Outstanding = 10000
Normal EBIT = $26000
EBIT at Expansion = Normal EBIT + 12%
=$26000 + 12%
=$29120
EBIT at Recession = Normal EBIT - 25%
=$26000 - 25%
=$19500
Value of Debt Issue = $65000
Interest Rate of Debt = 6%
Therefore, we need first calculate following
Market Price Per Share
= Market Value of RAK Inc / No of Shares Outstanding
= $200000 / 10000
= $20
Interest on Debt = Value of Debt * Interest Rate of Debt
= $65000 * 6%
= $3900
No of Shares Repurchased
= Value of Debt used for Repurchase of Shares / Market Price Per Share
= $65000 / $20
= 3250 Shares
No of Shares Outstanding after recapitalization
= No of Shares Outstanding before recapitalization - No of Shares repurchased
= 10000 - 3250
= 6750
Now,
a) 1 Calculation of EPS before any Debt is Issued
Particulars Recession Normal Expansion
A. EBIT 19500 26000 29120
B. No of Shares Outstanding 10000 10000 10000
C. EPS (A / B)                     1.95           2.60             2.91
a) 2 Calculation of % Changes in EPS
% Changes in EPS for Recession
= [(EPS of Recession - EPS of Normal) / EPS of Normal]*100
=[(1.95 - 2.60) / 2.60] *100
= -0.65 / 2.60 *100
= - 25%
% Changes in EPS for Expansion
= [(EPS of Expansion - EPS of Normal) / EPS of Normal]*100
=[(2.91 - 2.60) / 2.60] *100
= 0.31 / 2.60 *100
= 11.92%
b) 1 Calculation of EPS after any Debt is Issued
Particulars Recession Normal Expansion
A. EBIT 19500 26000 29120
B. Interest 3900 3900 3900
C. Earnings After Interest (A-B) 15600 22100 25220
D. No of Shares Outstanding 6750 6750 6750
E. EPS (C / D)                     2.31           3.27             3.74
b) 2 Calculation of % Changes in EPS
% Changes in EPS for Recession
= [(EPS of Recession - EPS of Normal) / EPS of Normal]*100
=[(2.31 - 3.27) / 3.27] *100
= -0.96 / 3.27 *100
= - 29.36%
% Changes in EPS for Expansion
= [(EPS of Expansion - EPS of Normal) / EPS of Normal]*100
=[(3.74 - 3.27) / 3.27] *100
= 0.47 / 3.27 *100
= 14.37%

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