Castle, Inc., has no debt outstanding and a total market value of $250,000. Earn
ID: 2597554 • Letter: C
Question
Castle, Inc., has no debt outstanding and a total market value of $250,000. Earnings before interest and taxes, EBIT, are projected to be $42,000 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 30 percent lower. The firm is considering a debt issue of $100,000 with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 10,000 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. a-2. Calculate the percentage changes in EPS when the economy expands or enters a recession. b-1. Calculate earnings per share (EPS) under each of the three economic scenarios assuming the company goes through with recapitalization. b-2. Given the recapitalization, calculate the percentage changes in EPS when the economy expands or enters a recession.
Explanation / Answer
Solution:
(A) Calculation of earnings per share (EPS) and percentage changes in EPS before any debt is issued under different economic scenarios:
(2.73-1.911)*100/2.73
= -30%
(3.2214-2.73)*100/2.73
= +18%
(B) Calculation of earnings per share (EPS) and percentage changes in EPS after the debt is issued under different economic scenarios:
(2.21-1.391)*100/2.21
= -37.06%
(2.7014-2.21)*100/2.21
= +22.24%
Particulars Recession Normal Expansion EBIT $29,400 $42,000 $49,560 Less: Interest 0 0 0 Less: Tax@35% $10,290 $14,700 $17,346 Net Income $19,110 $27,300 $32,214 EPS (Net income/Outstanding shares) $1.911 $2.73 $3.2214 % change in EPS(2.73-1.911)*100/2.73
= -30%
__(3.2214-2.73)*100/2.73
= +18%
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