Question

Suppose you work for Shah Corporation as a Chief Financial Officer (CFO). The firm has no debt outstanding. Total market value of the firm is $5,977,000. Earnings before interest and taxes, EBIT, are projected to be $393,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 20% higher. If there is a recession, then EBIT will be 30% lower. Shah Corporation is considering a $1,175,000 debt issue with a 6% interest rate. The proceeds will be used to repurchase shares of stock. There are currently 96,000 shares outstanding. The tax rate is 35%. Based on the given information, please answer questions a and b.

a)        Calculate earnings per share (EPS) under each of the three economic scenarios before any debt is issued. Also calculate the percentage changes in EPS when the economy expands or enters a recession.

Repeat part (a) assuming that the company goes through with recapitalization.

Answer 1

Solution:

Market price per share=market value of the firm/No. of shares outstanding

=$5,977,000/96000

=$62.26

a)In case firm has no debt.earning available to shareholders is earning after tax,that is:

=EBIT(1-tax rate)

Thus Earning available to shareholders under three economic scenarios before any debt is issued:

i)Normal

=$393,000(1-0.35)

=$255,450

ii)Strong expansion

=$393,000(1+0.20)*(1-0.35)

=$306,540

iii)Recession

=$393,000(1-0.30)*(1-0.35)

=$178,815

EPS=Earning available to shareholders/No. of shares outstanding

No. of shares outstanding under all three economic scenarios are same.Thus EPS under:

i)Normal

=$255,450/96000

=$2.66

ii)Strong expansion

=$306,540/96000

=$3.19

iii)Recession

=$178,815/96000

=$1.86

b)After issue of debt earning available to shareholders is;

=(EBIT-Interest)*(1-tax rate)

and no. of shares outstanding will be as follow

=No. of shares before issue of debt-No. of shares repurchase

=96000-($1,175,000/$62.26)

=96000-18,873

=77,127

EPS is;

EPS=Earning available to shareholders/No. of shares outstanding after issue of debt

i)Normal

EPS=[$393,000-($1,175,000*6%)](1-0.35)/77,127

=$209625/77,127

=$2.72

ii)Strong expansion

EPS=[$393,000(1+0.20)-$70500]*(1-0.35)/77,127

=$3.38

iii)Recession

EPS=[$393,000(1-0.30)-$70,500]*(1-0.35)/77,127

=$132,990/77,127

=$1.72