Question

Sunrise, Inc., has no debt outstanding and a total market value of $200,000. Earnings before interest and taxes, EBIT, are projected to be $24,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 15 percent higher. If there is a recession, then EBIT will be 30 percent lower. The company is considering a $70,000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 8,000 shares outstanding. Ignore taxes for this problem. Assume the stock price is constant under all scenarios. 1. Calculate earnings per share (EPS) under each of the three economic scenarios before any debt is issued. 2. Calculate the percentage changes in EPS when the economy expands or enters a recession. 3.Calculate earnings per share (EPS) under each of the three economic scenarios assuming the company goes through with recapitalization. 4. Given the recapitalization, calculate the percentage changes in EPS when the economy expands or enters a recession

Answer 1

Solution:
1.		EPS
	Recession	2.10
	Normal	3.00
	Expansion	3.45
Working Notes:
		Recession	Normal	Expansion
a	EBIT	16,800	24,000	27,600
		[24,000 x (1-0.30)]		[24,000 x (1 + 0.15)]
	÷
b	No of shares	8,000	8,000	8,000
c=a/b	EPS	2.10	3.00	3.45
	Change is EPS %	-30%	0	15%
	[new-normal)/normal]	[(2.10 - 3)/3]		[(3.45 - 3)/3]
2.		Percentage changes in EPS
	Recession	-30	%
	Expansion	15	%
Notes:	See above working notes:
3.		EPS
	Recession	2.29
	Normal	3.67
	Expansion	4.37
Working Notes:
	As per the given condition if it goes for recapitalization
	Its will raised debt and used them to repurchase share and interest on debt , by this no of shares will decrease and net income available to equity shareholders will also decrease by interest expense, as there is not taxes we will not tax benefit on interest expenses.
	Share price per share = Market value / no of shares outstanding
	Share price per share = $200,000 /8,000
	Share price per share = $25
	Amount raised as debt = $70,000
	Interest expense = Debt x interest rate
	Interest expense = $70,000 x 7%
	Interest expense = $4,900
	No of shares repurchased = Amount raised / Share price per share
	No of shares repurchased = $70,000 / $25
	No of shares repurchased = 2800
	Now the new no shares = 8,000- 2800=5200 shares
		Recession	Normal	Expansion
	EBIT	16,800	24,000	27,600
		[24,000 x (1-0.30)]		[24,000 x (1 + 0.15)]
	Less: Interest Expense	4900	4900	4900
a	Net income for Equity shareholders	11,900	19,100	22,700
	÷
b	No of shares	5,200	5,200	5,200
c=a/b	EPS	2.29	3.67	4.37
	Change is EPS %	-37.70%	0.00%	18.85%
	[new-normal)/normal]	[(2.2884615 - 3.673077)/3.673077]		[(4.3653846 - 3.673077)/3.673077]
4.		Percentage changes in EPS
	Recession	-37.70	%
	Expansion	18.85	%
Notes:	See above working note of 3.
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