Northern Wood Products is an all-equity firm with 16,000 shares of stock outstan

Question

Northern Wood Products is an all-equity firm with 16,000 shares of stock outstanding and a total market value of $352,000. Based on its current capital structure, the firm is expected to have earnings before interest and taxes of $26,000 if the economy is normal, $3,000 if the economy is in a recession, and $33,000 if the economy booms. Ignore taxes. Management is considering issuing $88,000 of debt with a 6 percent coupon rate. If the firm issues the debt, the proceeds will be used to repurchase stock. What will the earnings per share be if the debt is issued and the economy is in a recession?

Explanation / Answer

Einstein, Inc., has no debt outstanding and a total market value of $1,250,000. Earnings before interest and taxes, EBIT, are projected to be $300,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 30 % higher. If there is a recession, then EBIT will be 60 percent lower. Einstein is considering a $100,000 debt issue with a 8 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 10,000 shares outstanding. Ignore taxes for this problem. 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 Normal EPS = $300,000 / 10,000 = $30 Expansion EPS = $30 x 1.3 = $39 Recession EPS = $30 x 0.4 = $12 No calculation is needed since the answer was already given. the percentage changes in EPS when the economy expands = + 30% the percentage changes in EPS when the economy enters a recession = - 60%

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