EBIT and Leverage. Kaelea, Inc., has no debt outstanding and a total market valu
ID: 2650013 • Letter: E
Question
EBIT and Leverage. Kaelea, Inc., has no debt outstanding and a total market value of $125,000. Earnings before interest and taxes, EBIT, are projected to be $10,400 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 20 percent higher. If there is a recession, then EBIT will be 35 percent lower. Kaelea is considering a $42,000 debt issue with a 6 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 6,250 shares outstanding. Ignore taxes for this problem.
a. Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is issued. Also, calculate the percentage changes in EPS when the economy expands or enters a recession.
b. Repeat part (a) assuming that Kaelea goes through with recapitalization. What do you observe?
Explanation / Answer
a. Normal Economic Condition
EBIT=10400
Earning after tax and interest=10400-0-0 =$ 10400
No of shares=6250
Earning per share=10400/6250= $ 1.664
Strong Expension
EBIT=10400*120%=12480
Earning after tax= 12480
EPS=12480/6250=2.00
percentage change=2-1.66/1.66=20% increase
Recession
EBIT=10400*65%=6760
EPS=6760/6250=1.08
Decrease in EPS=1.08-1.66/1.66=35% decrease
b. Recapitalisation
New EAT=EBIT-interest =10400-42000*6%=7880
Market Price of 6250 shares is 125000
MPS=125000/6250=$20
No of shares purchased=42000/20=2100
Shares Outstanding=6250-2100=4150
EPS=7880/4150= $1.90
Increase in EPS=1.90-1.66/1.66= 15%
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