Northside, Inc. has no debt outstanding and a total market value of $175,000. Ea

Question

Northside, Inc. has no debt outstanding and a total market value of $175,000. Earnings before interest and taxes, are projected to be $16,000 if economic conditions are normal. If there is strong expansion in the economy, the EBIT will be 30% higher. If there is a recession, the EBIT will be 70 % lower. The company is considering a $70,000 debt issue with an interest rate of 7%. The proceeds will be used to repurchase shares of stock. There are currently 2,500 shares outstanding. Ignoring taxes, what will be the percentage change in EPS before restructuring compared to after restructuring if the economy has a strong expansion? 27.40% Can't figure out how thy got 27.40% as the answer.

Explanation / Answer

Market value of company = $175,000

Number of outstanding share = 2,500

Price per share = $175,000 / 2,500

                         = $70

Price per share of company is $70.

Current EBIT = $16,000

EBIT in case of Expansion = $16,000 × (1+30%)

                                            = $20,800

EBIT in case of recession = $16,000 × (1 - 70%)

                                            = $4,800

Company planning to raise 70,000 as debt to repurchase stock. Interest rate on debt is 7%.

Total interest on debt = $70,000 × 7%

                                   = $4,900

Total number of share repurchase from $70,000 at current price of $70 per share is calculated below:

Number of share repurchase = $70,000 / $70

                                              = $1,000

After repurchase number of share remains = 2,500 – 1,000

                                                                    = 1,500

Now earnings per share in normal case is calculated below:

EPS = ($16,000 - $4,900) / 1,500

        = $7.40

Earnings per share in case of normal economy is $7.40.

Earnings per share in expansion case is calculated below:

EPS = ($20,800 - $4,900) / 1,500

        = $10.60

Earnings per share in case of expansion economy is $10.60.

Earnings per share in recession case is calculated below:

EPS = ($4,800 - $4,900) / 1,500

        = -$0.67

Earnings per share in case of recession economy is -$0.67.

b.

Percentage change in EPS from normal economy to expansion economy is calculated below:

= ($10.60 – $7.40) / $7.40

=43.24%

Hence, Percentage change in EPS from normal economy to expansion economy is 43.24%

Percentage change in EPS from normal economy to recession economy is calculated below:

= (-$0.67 – $7.40) / $7.40

= -109.05%

Hence, Percentage change in EPS from normal economy to recession economy is -109.05%

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