EBIT and Leverage Money, Inc., has no debt outstanding and a total market value

Question

EBIT and Leverage Money, Inc., has no debt outstanding and a total market value of $275,000. Earnings before interest and taxes, EBIT, are projected to be $21,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT wIll be 25 percent higher. If there is a recession, then EBIT will be 40 percent lower.Money is considering a $99,000 debt issue with an 8 percent interest rate. The proceeds will be used to repurchase shares of stock.There are currently 5,000shares outstanding,ignore taxes for this problem.
lower.

a. Calculate earnings per share, EPS, under each of the three economic?scenarios (normal economic condition,normal economic condition,strong expansion economic conditions)
before any debt?is?issued. Also calculate the percentage changes in EPS when the economy expands or enters a recession.
b. Repeat part (a) assuming that Money goes through with recapitalization. What do you observe?


  

Explanation / Answer

Earning per share = EBIT/No. of shares

Normal = 21000/5000 =$4.2

Strong = 21000(1.25)/5000 =$5.25

Recession = 21000(1-0.4)/5000 =$2.52

Percentage changes in EPS:

Normal to strong = ($5.25-$4.2)/$4.2=25%

Normal to recession = ($2.52-$4.2)/$4.2= -40%

b. Value per share = $275,000/5000 = $55 per share

If $99,000 worth of debt is raised to retire stock, then there will be buying back of $99,000/$55 = 1,800 shares. So, after recapitalization there will be 5000 - 1800 = 3200 shares outstanding

We wil reduce EBIT by the interest expense of $99,000*8% = $7,920, New EBIT:

EBIT Strong Normal Recession

EBIT $26,250 $21,000 $12,600

Less Interest $7920     $7920   $7920

New EBIT $18,330 $13,080 $4,680

Earning per share = EBIT/No. of shares

Normal = $13,080 /3200 =$4.0875

Strong = $18,330/3200 =$5.73

Recession = $4,680/3200 =$1.4625

Percentage changes in EPS:

Normal to strong = ($5.73-$4.0875)/$4.0875=40.18%

Normal to recession = ($1.4625-$4.0875)/$4.0875= -64.22%

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