Question

Castle, Inc., has no debt outstanding and a total market value of $240,000. 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 18 percent higher. If there is a recession, then EBIT will be 20 percent lower. The firm is considering a debt issue of $150,000 with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 15,000 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. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to the nearest whole number, e.g., 32.)

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. (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. (A negative answer 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	%

Answer 1

a-1

EPS = EBIT*(1-tax rate)/shares outstanding

Recession

EPS = EBIT*(1-recession impact%)*(1-tax rate)/shares outstanding

EPS=26000*(1-0.2)*(1-0)/15000

EPS=1.39

Normal

EPS = EBIT*(1-tax rate)/shares outstanding

EPS=26000*(1-0)/15000

EPS=1.73

Expansion

EPS = EBIT*(1+Growth impact%)*(1-tax rate)/shares outstanding

EPS=26000*(1+0.18)*(1-0)/15000

EPS=2.05

a-2

%age change in EPS for Recession

=(EPS recession/EPS normal-1)*100

=(1.3867/1.7333-1)*100

=-20%

%age change in EPS for Growth

=(EPS Growth/EPS normal-1)*100

=(2.0453/1.7333-1)*100

=18%

b-1

New no. of shares = old shares-debt/(Market value/old shares)

=15000-150000/(240000/15000)

=5625

EPS = (EBIT-debt*interest%)*(1-tax rate)/new shares outstanding

Recession

EPS = (EBIT*(1-recession impact%)-debt*interest %age)*(1-tax rate)/new shares outstanding

EPS=(26000*(1-0.2)-150000*0.08)*(1-0)/5625

EPS=1.56

Normal

EPS = (EBIT-debt*interest%)*(1-tax rate)/new shares outstanding

EPS=(26000-150000*0.08)*(1-0)/5625

EPS=2.49

Expansion

EPS = (EBIT*(1+growth impact%)-debt*interest %age)*(1-tax rate)/new shares outstanding

EPS=(26000*(1+0.18)-150000*0.08)*(1-0)/5625

EPS=3.32

b-2

%age change in EPS for Recession

=(EPS recession/EPS normal-1)*100

=(1.5644/2.4889-1)*100

=-37.14%

%age change in EPS for Growth

=(EPS Growth/EPS normal-1)*100

=(3.3209/2.4889-1)*100

=33.43%