Pendergast, Inc., has no debt outstanding and a total market value of $200,000.

Question

Pendergast, Inc., has no debt outstanding and a total market value of $200,000. Earnings before interest and taxes, EBIT, are projected to be $24,000 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. Pendergast is considering a $70,000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 8,000 shares outstanding. Pendergast 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. (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.) Percentage changes in EPS Recession % Expansion %

b-1 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)) 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. Round your answers to 2 decimal places. (e.g., 32.16)) Percentage changes in EPS Recession % Expansion %

Explanation / Answer

a1: EBIT =24000. After tax, net income = 24000 * (1-0.35) = 15,600

Net Income in recession = 15,600 * (1-0.3) = 10.920, EPS in recession = Net Income/Total shares = 10.920/8000 = 1.365

Net Income in normal =15,600. EPS under normal economy = 15,600/8000 = 1.95

Net Income in Expansion = 15,600*(1+0.15) = 17,940. EPS in expansion = 17,940/8000 = 2.2425

a2: % chnage in EPS Recession = (1.365-1.95)/1.95 = -30%

% chnage in EPS in expnasion = (2.2425-1.95)/1.95 = 15%

b1.The share price before repurchase = 200,000/8,000 = 25

When 70,000 capital is repurchased, the amount repurchased = 70,000/25 = 2,800 shares will be repurchased.

So new number of shares = 8000 -2800 = 5,200

So EBIT =24,000, Interest = 7% of 70,000 = = 4,900. EBT = 19,100

Net Income = 19,100*(1-0.35) = 12,415

Expansion = 14,277.25

Recession = 8,690.50

EPS in Recession = 8,690.50/5200 = 1.67125

EPS in Normal economy = 12,415/5200 = 2.3875

EPS in Expansion = 14,277.25/5200 = 2.7456

b2. % change in recession = (1.67125-2.3875)/2.3875 = -0.3 -30%

% chnage in expansion =(2.7456-2.3875)/2.3875 =0.15 = 15%

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