Question

Kaelea, Inc., has no debt outstanding and a total market value of $110,000. Earnings before interest and taxes, EBIT, are projected to be $8,800 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 23 percent higher. If there is a recession, then EBIT will be 32 percent lower. The company is considering a $36,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 4,400 shares outstanding. Ignore taxes for this problem.

a. 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	$

b. 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 the nearest whole number, e.g., 32.)

	%ΔEPS
Recession	%
Expansion	%

Assume the company goes through with recapitalization.

c. Calculate earnings per share, EPS, under each of the three economic scenarios after the recapitalization. (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)

	EPS
Recession	$
Normal	$
Expansion	$

d. 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.)

	%ΔEPS
Recession	%
Expansion	%

Answer 1

Normal:

EBIT = $8,800

Recession:

EBIT = $8,800 - 32% * $8,800
EBIT = $5,984

Expansion:

EBIT = $8,800 + 23% * $8,800
EBIT = $10,824

Answer a.

Total Value = $110,000
Number of shares outstanding = 4,400

Price per share = Total Value / Number of shares outstanding
Price per share = $110,000 / 4,400
Price per share = $25.00

Answer b.

If economy expand:

Percentage Change in EPS = ($2.46 - $2.00) / $2.00
Percentage Change in EPS = 23.00%

If economy collapse:

Percentage Change in EPS = ($1.36 - $2.00) / $2.00
Percentage Change in EPS = -32.00%

Answer c.

Value of Debt = $36,000

Interest Expense = 6% * $36,000
Interest Expense = $2,160

Value of Equity = $74,000
Price per share = $25.00

Number of shares outstanding = $74,000 / $25.00
Number of shares outstanding = 2,960

Answer d.

If economy expand:

Percentage Change in EPS = ($2.93 - $2.24) / $2.24
Percentage Change in EPS = 30.80%

If economy collapse:

Percentage Change in EPS = ($1.29 - $2.24) / $2.24
Percentage Change in EPS = -42.41%