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Castle, Inc., has no debt outstanding and a total market value of $150,000. Earnings before interest and taxes, EBIT, are projected to be $28,000 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 25 percent lower. The firm is considering a debt issue of $60,000 with an interest rate of 7 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	$

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.)

		EPS
Recession	$
Normal	$
Expansion	$

Answer 1

(a) Expansion: Normal EBIT = $ 28000 and Growth of EBIT = 20 %

New EBIT = 28000 x 1.2 = $ 33600

Less: Interest Expense = $ 0 (as the firm is entirely equity financed)

Profit Before Tax = $ 33600

Less: Tax Expense = $ 0 (as there are no taxes)

Net Income = $ 33600

NUmber of Shares Outstanding = N = 10000

EPS = 33600 / 10000 = $ 3.36

Normal:

EBIT = $ 28000

Less: Interest Expense = $ 0 (as the firm is entirely equity financed)

Profit Before Tax = $ 28000

Less: Tax Expense = $ 0 (as there are no taxes)

Net Income = $ 28000

NUmber of Shares Outstanding = N = 10000

EPS = 28000 / 10000 = $ 2.8

Recession: Normal EBIT = $ 28000, Growth Rate = - 25 %

New EBIT = 28000 x (1-0.25) = $ 21000

Less: Interest Expense = $ 0 (as the firm is entirely equity financed)

Profit Before Tax = $ 21000

Less: Tax Expense = $ 0 (as there are no taxes)

Net Income = $ 21000

NUmber of Shares Outstanding = N = 10000

EPS = 21000 / 10000 = $ 2.1

(b) If the firm raises $ 60000 at an interest rate of 7%, the overall firm value remains fixed at $ 150000 as there are no taxes and hence no interest tax shields.

Price per Share = Firm Value / N = 150000 / 10000 = $ 15

Number of Shares Repurchased = 60000 / 15 = 4000

Number of Shares Remaining = 6000 = N'

Expansion:

EBIT = $ 33600

Less: Interest Expense = 60000 x 0.07 = $ 29400

PBT = $ 29400

Less: Tax Expense = $ 0

Net Income = $ 29400

EPS = Net Income / N' = 29400 / 6000 = $ 4.9

Normal:

EBIT = $ 2800

Less: Interest Expense = 60000 x 0.07 = $ 4200

PBT = $ 23800

Less: Tax Expense = $ 0

Net Income = $ 23800

EPS = Net Income / N' = 23800 / 6000 = $ 3.967 ~ $ 3.97

Recession:

EBIT = $ 21000

Less: Interest Expense = 60000 x 0.07 = $ 4200

PBT = $ 16800

Less: Tax Expense = $ 0

Net Income = $ 16800

EPS = Net Income / N' = 16800 / 6000 = $ 2.8