Question

Ghost, 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. The company 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.)

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 2 decimal places, e.g., 32.16.)

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.)

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.)

a-1.Recession EPS

Normal EPS

Expansion EPS

a-2.Recession percentage change in EPS%

Expansion percentage change in EPS%

b-1.Recession EPS

Normal EPS

b-2.Expansion EPS

Recession percentage change in EPS%

Expansion percentage change in EPS%

Answer 1

Normal:

EBIT = $26,000

Recession:

EBIT = $26,000 - 25% * $26,000
EBIT = $19,500

Expansion:

EBIT = $26,000 + 12% * $26,000
EBIT = $29,120

Answer a-1.

Total Value = $200,000
Number of shares outstanding = 10,000

Price per share = Total Value / Number of shares outstanding
Price per share = $200,000 / 10,000
Price per share = $20.00

Answer a-2.

If economy expand:

Percentage Change in EPS = ($2.91 - $2.60) / $2.60
Percentage Change in EPS = 11.92%

If economy collapse:

Percentage Change in EPS = ($1.95 - $2.60) / $2.60
Percentage Change in EPS = -25.00%

Answer b-1.

Value of Debt = $65,000

Interest Expense = 6% * $65,000
Interest Expense = $3,900

Value of Equity = $135,000
Price per share = $20.00

Number of shares outstanding = $135,000 / $20.00
Number of shares outstanding = 6,750

Answer b-2.

If economy expand:

Percentage Change in EPS = ($3.74 - $3.27) / $3.27
Percentage Change in EPS = 14.37%

If economy collapse:

Percentage Change in EPS = ($2.31 - $3.27) / $3.27
Percentage Change in EPS = -29.36%