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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 | % | |
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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