Music City, Inc., has no debt outstanding and a total market value of $295,000.
ID: 2728760 • Letter: M
Question
Music City, Inc., has no debt outstanding and a total market value of $295,000. Earnings before interest and taxes, EBIT, are projected to be $23,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 25 percent higher. If there is a recession, then EBIT will be 40 percent lower. The company is considering an $88,500 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,000 shares outstanding. Ignore taxes for this problem.
a. 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. b. Repeat part (a) assuming that the company goes through with recapitalization. What do you observe?
2. Repeat parts (a) and (b) in Problem 1 assuming the company has a tax rate of 35 percent.
Explanation / Answer
Answer
Statement showing calculation of EPS before any debt issued and ignoring tax
= (5.75/4.6)x100 = 125%
Eps increases by 25% from normal situation
=(2.76/4.6)x100 = 60%
Eps decreases by 40% from normal situation
Statement showing calculation of EPS if company goes through with recapitalization ignoring tax
= (6.19/4.55)x100 = 136%
Eps increases by 36% from normal situation
=(1.92/4.55)x100 = 42.20%
Eps decreases by 42.20% from normal situatio
Working Note 1:
Market price of share = market value of company/no. of shares = $ 295,000/5000 = 59
No. of shares bought back by issuing debt = 88,500/59 per share = 1500 shares
No. of shares after buyback = 5000 - 1500 = 3500 shares
From above calculation I have observed that due to recapitalization EPS of company increases in expansion scenario and decreases in other two scenarios
Answer 2
Statement showing calculation of EPS before any debt issued but after considering tax
= (3.73/2.99)x100 = 124.75%
Eps increases by 24.75% from normal situation
=(1.794/2.99)x100 = 60%
Eps decreases by 40% from normal situation
Statement showing calculation of EPS if company goes through with recapitalization and considering tax
= (4.0244/2.9565)x100 = 136.12%
Eps increases by 36.12% from normal situation
=(1.248/2.9565)x100 = 42.20%
Eps decreases by 42.20% from normal situatio
Working Note 1:
Market price of share = market value of company/no. of shares = $ 295,000/5000 = 59
No. of shares bought back by issuing debt = 88,500/59 per share = 1500 shares
No. of shares after buyback = 5000 - 1500 = 3500 shares
Srl No. Particular Normal Situation Expansion Recession 1 Earnings 23000 23000+(23000 x25%)= 28750 23000 -(23000 x40%)= 13800 2 No. of shares outstanding 5000 5000 5000 3 EPS = (Earnings/No. of shares outstanding) 4.6 5.75 2.76 4 % change in EPS if economy expands or enters a recession -= (5.75/4.6)x100 = 125%
Eps increases by 25% from normal situation
=(2.76/4.6)x100 = 60%
Eps decreases by 40% from normal situation
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.