Castle, Inc., has no debt outstanding and a total market value of $200,000. Earn

Question

Castle, Inc., has no debt outstanding and a total market value of $200,000. Earnings before interest and taxes, EBIT, are projected to be $24,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 15 percent higher. If there is a recession, then EBIT will be 30 percent lower. The firm is considering a debt issue of $70,000 with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 8,000 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. (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)

a-2. Calculate the percentage changes in EPS when the economy expands or enters a recession. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to the nearest whole number, e.g., 32.)

b-1. Calculate earnings per share (EPS) under each of the three economic scenarios assuming the company goes through with recapitalization. (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)

b-2. Given the recapitalization, calculate the percentage changes in EPS when the economy expands or enters a recession. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
  

Explanation / Answer

EBIT in normal Scenario = 24000
EBIT after Tax = 24000 * (1 - 35%) = 15,600

EBIT in recession = 24000 * ( 1-30%) = 16800
EBIT after Tax =16800 * (1 - 35%) = 10,920

EBIT in boom = 24000* ( 1+15%) = 27,600
EBIT after Tax = 27600 * (1 - 35%) = 17,940
No of shares = 8000
a-1 EPS in recession = 10920/8000 = 1.37
EPS in Normal = 15600/8000 = 1.95
EPS in Boom = 17,940/8000 = 2.24

a-2)Percentage change in EPS when it goes into recession = (1.365-1.95)/1.95 = -30%
Percentage change in EPS when it goes into boom = (2.2425-1.95)/1.95 = 15%

c-1)
earnings per share (EPS) under each of the three economic scenarios assuming the company goes through with recapitalization.
EBIT in normal Scenario = 24000
EAT= (24000 - Interest)* (1 - 35%) = (24000 - 70,000*7%))* (1 - 35%) = 12415

EBIT in recession = 24000 * ( 1-30%) = 16800
EBIT after Tax =(16800 - Interest)* (1 - 35%) = (16800 - 70,000*7%))* (1 - 35%)= 7735

EBIT in boom = 24000* ( 1+15%) = 27,600
EBIT after Tax = (27600 - Interest)* (1 - 35%) = (27600 - 70,000*7%))* (1 - 35%)= 14755
No of shares before debt issue= 8000
Price Per share = 200000/8000 = 25
No of Shares outstanding after Debt issue = 8000 - 70,000/25 = 5200

EPS in recession =  7735/5200 = 1.4875
EPS in Normal =   12415/5200 = 2.3875
EPS in Boom =   14755/5200= 2.8375

Percentage change in EPS when it goes into recession = (1.4875-2.3875)/2.3875= -39.70%
Percentage change in EPS when it goes into boom = (2.8375-2.3875)/2.3875 = 18.85%

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