Question

Ghost, Inc., has no debt outstanding and a total market value of $250,000. Earnings before interest and taxes, EBIT, are projected to be $40,000 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 20 percent lower. The company is considering a $105,000 debt issue with an interest rate of 4 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.) Find recession EPS, normal EPS, expansion EPS
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.) Find Recession percentage change in EPS Expansion percentage change in EPS
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.) Find recession EPS, normal EPS, expansion EPS
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.) Find Expansion EPS Recession percentage change in EPS Expansion percentage change in EPS

Answer 1

a-1 EBIT in normal economic conditions = 40000, Debt = 0, Interest expense = 0,

If we ignore taxes, then tax rate = 0%

Net income in normal economic conditions = (EBIT - interest)(1-tax rate) = (40000 - 0)(1-0%) = 40000

EPS in normal economic conditions = Net income / No of shares outstanding = 40000 / 10000 = 4.00

EBIT in strong expansion = EBIT in normal economic conditions x ( 1 + 20%) = 40000 x 1.20 = 48000

Net income in strong expansion conditions = (EBIT - interest)(1-tax rate) = (48000 - 0)(1-0%) = 48000

EPS in strong expansion conditions = Net income / No of shares outstanding = 48000 / 10000 = 4.80

EBIT in recession = EBIT in normal economic conditions x ( 1 - 20%) = 40000 x 0.80 = 32000

Net income in recession conditions = (EBIT - interest)(1-tax rate) = (32000 - 0)(1-0%) = 32000

EPS in recession conditions = Net income / No of shares outstanding = 32000 / 10000 = 3.20

a-2    Percentage change in EPS when economy enters expansion = (EPS in expansion / EPS in normal economic conditions) - 1 = (4.80/4.00) - 1 = 1.20 - 1 = 0.20 = 20.00%

Percentage change in EPS when economy enters recession = (EPS in recession / EPS in normal economic conditions) - 1 = (3.20/4.00) - 1 = 0.80 - 1 = -0.20 = - 20.00%

b-1 Before recapitalization, Total market value of company = Value of Equity = No of shares outstanding x price per share

250000 = 10000 x price per share

Price per share = 250000/ 10000 = $25

Total debt issued = = 105000,

No of shares repurchased = Total debt issued / price per share = 105000 / 25 = 4200

No of shares outstanding after recapitalization = Initial no of shares outstanding before recapitalization - shares repurchased = 10000 - 4200 = 5800

Interest expense after recapitalization = debt x rate of interest = 105000 x 4% = 4200

We will now calculate the EPS after recapitalization under three conditions

Net income in normal economic conditions = (EBIT - interest)(1-tax rate) = (40000 - 4200)(1-0%) = 35800

EPS in normal economic conditions = Net income / No of shares outstanding = 35800 / 5800 = 6.1724 = 6.17

EBIT in strong expansion = EBIT in normal economic conditions x ( 1 + 20%) = 40000 x 1.20 = 48000

Net income in strong expansion conditions = (EBIT - interest)(1-tax rate) = (48000 - 4200)(1-0%) = 43800

EPS in strong expansion conditions = Net income / No of shares outstanding = 43800 / 5800 = 7.5517 = 7.55

EBIT in recession = EBIT in normal economic conditions x ( 1 - 20%) = 40000 x 0.80 = 32000

Net income in recession conditions = (EBIT - interest)(1-tax rate) = (32000 - 4200)(1-0%) = 27800

EPS in recession conditions = Net income / No of shares outstanding = 27800 / 5800 = 4.7931 = 4.79

b-2

Percentage change in EPS when economy enters expansion = (EPS in expansion / EPS in normal economic conditions) - 1 = (7.55/6.17) - 1 = 1.223662 - 1 = 0.223662 = 22.3662% = 22.37%

Percentage change in EPS when economy enters recession = (EPS in recession / EPS in normal economic conditions) - 1 = (4.79/6.17) - 1 = 0.776337 - 1 = -0.223662 = -22.3662% = -22.37%