RAK, Inc., has no debt outstanding and a total market value of $240,000. Earning

Question

RAK, Inc., has no debt outstanding and a total market value of $240,000. Earnings before interest and taxes, EBIT, are projected to be $32,000 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. RAK is considering a $80,000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 15,000 shares outstanding. Ignore taxes for this problem.

a-1 Calculate earnings per share (EPS) under each of the three economic scenarios before any debt is issued.

a-2 Calculate the percentage changes in EPS when the economy expands or enters a recession

b-1

Calculate earnings per share (EPS) under each of the three economic scenarios assuming the company goes through with recapitalization

b-2 Given the recapitalization, calculate the percentage changes in EPS when the economy expands or enters a recession

Calculate earnings per share (EPS) under each of the three economic scenarios assuming the company goes through with recapitalization

b-2 Given the recapitalization, calculate the percentage changes in EPS when the economy expands or enters a recession

Explanation / Answer

RAK Inc.      1 Current Situation Normal   Expansion Recession a1 Equity value       240,000    240,000            240,000 No of Equity shares           15,000      15,000              15,000 Debt (5% interest rate )                   -                 -                         -   EBIT           32,000      36,800              22,400 Less Interest Income before Tax Less Tax Net Income for Equity holders         32,000      36,800              22,400 EPS =              2.13           2.45                   1.49 a2 Details Normal   Expansion Recession % Change in ROE= 15.00% -30.00%      2 b1 After recapitalization : Revised situation Normal   Expansion Recession Equity value       160,000    160,000            160,000 No of Equity shares           10,000      10,000              10,000 Debt (7% interest rate )         80,000      80,000              80,000 EBIT           32,000      36,800              22,400 Less Interest            5,600        5,600                5,600 Income before Tax Less Tax Net Income for Equity holders         26,400      31,200              16,800 EPS =              2.64           3.12                   1.68 b2 Details Normal   Expansion Recession % Change in ROE= 15.38% -85.71%

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