Question

Castle, Inc., has no debt outstanding and a total market value of $220,000. 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 15 percent higher. If there is a recession, then EBIT will be 20 percent lower. The firm is considering a debt issue of $120,000 with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 11,000 shares outstanding. The firm has a tax rate 35 percent. Assume the stock price remains constant. 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 $ 9.45 9.45 Incorrect Normal $ 11.82 11.82 Incorrect Expansion $ 13.59 13.59 Incorrect 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 -20 -20 Correct % Expansion 15 15 Correct % 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 $ 11.20 11.20 Incorrect Normal $ 16.40 16.40 Incorrect Expansion $ 20.30 20.30 Incorrect 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 -31.71 -31.71 Correct % Expansion 23.78 23.78 Correct

Answer 1

a-1.				Recession	Normal	Expansion
	EBIT			20800	26000	29900
				26000*(100-20)%		26000*(100+15)%
				(20% lower)		(15% higher)
	Less: Interest			0	0	0
	(Since no debt is issued)
	EBT			20800	26000	29900
	Less: Tax @ 35%			7280	9100	10465
	Net income		(a)	13520	16900	19435
	Shares outstanding		(b)	11000	11000	11000
	EPS		(a)/(b)	1.23	1.54	1.77
a-2.	Recession:
	% change in EPS=(EPS at normal-EPS at recession)/EPS at normal=(1.54-1.23)/1.54=0.31/1.54=0.2013=20.13 %
	Expansion:
	% change in EPS=(EPS at expansion-EPS at normal)/EPS at normal=(1.77-1.54)/1.54=0.23/1.54=0.1494=14.94 %
b-1.	Share price=Market value/Shares outstanding=220000/11000=$ 20 per share
	Shares repurchased through re-capitalization=Debt issued/share price=120000/20=6000 shares
	Remaining shares outstanding=11000-6000=5000 shares
	Interst expense=Debt issued*Interest rate=120000*8%=$ 9600
				Recession	Normal	Expansion
	EBIT			20800	26000	29900
				26000*(100-20)%		26000*(100+15)%
				(20% lower)		(15% higher)
	Less: Interest			9600	9600	9600
	(Since no debt is issued)
	EBT			11200	16400	20300
	Less: Tax @ 35%			3920	5740	7105
	Net income		(a)	7280	10660	13195
	Shares outstanding		(b)	5000	5000	5000
	EPS		(a)/(b)	1.46	2.13	2.64
b-2.	Recession:
	% change in EPS=(EPS at normal-EPS at recession)/EPS at normal=(2.13-1.46)/2.13=0.67/2.13=0.3146=31.46 %
	Expansion:
	% change in EPS=(EPS at expansion-EPS at normal)/EPS at normal=(2.64-2.13)/2.13=0.51/2.13=0.2394=23.94 %