Pendergast, Inc., has no debt outstanding and a total market value of $220,000.

Question

Pendergast, Inc., has no debt outstanding and a total market value of $220,000. Earnings before interest and taxes, EBIT, are projected to be $26,000 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 20 percent lower. Pendergast is considering a $120,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 11,000 shares outstanding. Pendergast has a tax rate of 35 percent.

Calculate earnings per share (EPS) under each of the three economic scenarios before any debt is issued. (Round your answers to 2 decimal places. (e.g., 32.16))

Calculate the percentage changes in EPS when the economy expands or enters a recession.(Negative amounts should be indicated by a minus sign.)

Assume that the company goes through with recapitalization. Calculate earnings per share (EPS) under each of the three economic scenarios assuming the company goes through with recapitalization.(Round your answers to 2 decimal places. (e.g., 32.16))

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. Round your answers to 2 decimal places. (e.g., 32.16))

Pendergast, Inc., has no debt outstanding and a total market value of $220,000. Earnings before interest and taxes, EBIT, are projected to be $26,000 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 20 percent lower. Pendergast is considering a $120,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 11,000 shares outstanding. Pendergast has a tax rate of 35 percent.

Explanation / Answer

a-1 Recession (EBITx(1- 20%) Normal (given) Expansion =EBIT x (1+15%) EBIT $20,800 $26,000 $29,900 Less: Tax @ 35% -$7,280 -$9,100 -$10,465 Net Income $13,520 $16,900 $19,435 Shares outstanding 11000 11000 11000 EPS = Net Income/ Shares outstanding $1.23 $1.54 $1.77 EPS Recession $1.23 Normal $1.54 Expansion $1.77 a-2 Percentage changes in EPS Recession = ($1.23 -$1.54)/$1.54 -20.00% Expansion = ($1.77 - $1.54)/$1.54 15.00% b-1 If the market value of the firm is $220,000 with 11,000 shares outstanding, then the value of one share of stock is: $220,000/11,000 = $20/share If $120,000 worth of debt is raised to retire stock, then you will be buying back $120,000/$20 or 6,000 shares. So, after recapitalization there will be 11,000 - 6,000 or 5,000 shares outstanding. Recession (EBITx(1- 20%) Normal (given) Expansion =EBIT x (1+15%) EBIT $20,800 $26,000 $29,900 Less:Interest ($120,000 x 8%) -$9,600 -$9,600 -$9,600 EBT $11,200 $16,400 $20,300 Less: Tax @ 35% -$3,920 -$5,740 -$7,105 Net Income $7,280 $10,660 $13,195 Shares outstanding 5000 5000 5000 EPS = Net Income/ Shares outstanding $1.46 $2.13 $2.64 EPS Recession $1.46 Normal $2.13 Expansion $2.64 b-2 Percentage changes in EPS Recession = ($1.46 -$2.13)/$2.13 -31.71% Expansion = ($2.64 - $2.13)/$2.13 23.78%

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