If a firm has no debt outstanding and a total market value of $125,000. Earnings

Question

If a firm has no debt outstanding and a total market value of $125,000. Earnings before interest and taxes are projected to be $10,400 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 20% higher. If there is recession then EBIT will be 35% lower.

The firm is considering a $42,000 debt issue with a 4% interest rate. The procedds will be issed to repurchase shares of stock. There are currently 6.25 shares outstanding (ignore taxes for this problem)

1. Calculate Earnings per Share under each of the economic scenarios before any debt is issued and also calculate the percentage changes in EPS when the economy expands or enters a recession.

2. If a recapitalization occurs what will be observed?

Explanation / Answer

1. Total Market Value without Debt = $125,000

EBIT if Economic Conditions are Normal: $10,400

Earning Per Share = 10,400 / 6.25 = $1,664

EBIT if Economic Condition is Strong EBIT will be increased by 20%: 10,400 x 120 / 100 = $12,480

EPS = 12,480 / 6.25 = $1,996.80

% Change in EPS = 20%

EBIT if Economic Condition is of recession: 10,400 x 65 / 100 = $6,760

EPS = 6,760 / 6.25 = $1,081.60

% Change in EPS = -35%

2. After recapitalization occurs than Firm will raise $42,000 Debt at the Rate of 4%. Share Repurchase by this amount: Price Per Share = 125,000 / 6.25 = $20,000 Per Share

Share Repurchase = 42,000 / 20,000 = 2.10

Outstanding Share after Repurchase = 6.25 - 2.10 = 4.15

Market Value = 4.15 x 20,000 = $83,000

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