RAK, Inc., has no debt outstanding and a total market value of $150,000. Earning
ID: 2732147 • Letter: R
Question
RAK, Inc., has no debt outstanding and a total market value of $150,000. Earnings before interest and taxes, EBIT, are projected to be $28,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 20 percent higher. If there is a recession, then EBIT will be 25 percent lower. RAK is considering a $60,000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 10,000 shares outstanding. RAK has a tax rate of 35 percent.
a-1 Calculate earnings per share (EPS) under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)
EPS Recession $
Normal $
Expansion $
a-2 Calculate the percentage changes in EPS when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
Percentage changes in EPS
Recession %
Expansion %
b-1 Calculate earnings per share (EPS) under each of the three economic scenarios assuming the company goes through with recapitalization. (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)
EPS Recession $
Normal $
Expansion $
b-2 Given the recapitalization, calculate the percentage changes in EPS when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
Percentage changes in EPS
Recession %
Expansion %
Explanation / Answer
Answer: a-1
Answer:a-2
% EPS going from Normal to Expansion: ($2.18 - $1.82)/$1.82 = .1978 or 19.78%
% EPS going from Normal to Recession: ($1.37 - $1.82)/$1.82 = -.2473 or -24.73%
Answer:b-1 If the market value of the firm is $150,000 with 10000 shares outstanding, then the value of one share of stock is: $150,000/10000 = $15/share.
If $60,000 worth of debt is raised to retire stock, then you will be buying back $60,000/$15 or 4,000 shares. So, after recapitalization there will be 10000 -4,000 or 6000 shares outstanding.
EBIT will be reduced by the amount of the interest on $60,000 in debt or $60,000 x .07= $4,200.
Answer:b-2
% EPS going from Normal to Expansion: ($3.19 - $2.58)/$2.58 = .2364 or 23.64%
% EPS going from Normal to Recession: ($1.82 - $2.58)/$2.58 = -.2946 or -29.46%
Particulars Recession Normal Expansion EBIT 21000 28000 33600 Less: interest 0 0 0 EBT 21000 28000 33600 Less: tax @35% 7350 9800 11760 Net income 13650 18200 21840 Number of shares outstanding 10000 10000 10000 EPS 1.37 1.82 2.18Related Questions
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