A company with market value of $250,000 has no debt. EBIT are expected to be $28

Question

A company with market value of $250,000 has no debt. EBIT are expected to be $28,000 under normal economic conditions, 30% more than that if the economy is strong, but only half that if there is a recession. The company is considering raising $90,000 in debt costing 7% to repurchase stock. Currently there are 5,000 shares outstanding. Ignoring taxes:

a. Calculate EPS under each economic condition before debt is issued.
b. Calculate the percentage changes in EPS when the economy goes from normal to strong and normal to recession.
c. Repeat (a) assuming that the debt was issued and shares were repurchased. What do you observe?

Part two:


Assume that the company in question above has a market to book value of 1.0. Ignore taxes.

a. Calculate the ROE under each of the three economic conditions before debt is issued.
b. Calculate the percentage changes in ROE when the economy goes from normal to strong and normal to recession.
c.Repeat (a) assuming that the debt was issued and shares were repurchased.
d. Repeat (a) and (c) assuming the company has a 35% tax rate.

Explanation / Answer

Part One a. EPS under normal economic conditions =$28,000/5,000 = $5.60 EPS under strong economic conditions =$28,000*1.3/5,000 = $7.28 EPS under week economic conditions =$28,000*.5/5,000 = $2.8 b. %change =( $7.28-$5.60 )/$5.60 = 30.00% c.After repurchase Current cost of shares =$250,000/5000=$50 No of shares purchased with debt raised=$90,000/$50 =1800 No of shares left =5000-1800=3200 Interest = $90,000*7% =$6300 EPS under normal economic conditions =($28,000-$6300)/3200 = $6.78125 EPS under strong economic conditions =($28,000*1.3-$6300)/3200 = $9.40625 EPS under week economic conditions =($28,000*.5-$6300)/3200 = $2.40625 Part Two Equity=$250,000 a. ROE under normal economic conditions =$28,000/$250,000 = 11.20% ROE under strong economic conditions =$28,000*1.3/$250,000 = 14.56% ROE under week economic conditions =$28,000*.5/$250,000 = 5.60% b. %change =(14.56%-11.20% )/11.20% = 30.00% c.After repurchase Equity =$250,000-$90,000= $160,000.00 Interest = $90,000*7% =$6300 ROE under normal economic conditions =($28,000-$6300)/$160,000.00 = 13.56% ROE under strong economic conditions =($28,000*1.3-$6300)/$160,000.00 = 18.81% ROE under week economic conditions =($28,000*.5-$6300)/$160,000.00 = 4.81%

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