Music City, Inc., has no debt outstanding and a total market value of $250,000.
ID: 2743904 • Letter: M
Question
Music City, Inc., has no debt outstanding and a total market value of $250,000. Earnings before interest and taxes, EBIT, are projected to be $40,000 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 20 percent lower. The company is considering a $105,000 debt issue with an interest rate of 4 percent. The proceeds will be used to repurchase shares of stock. There are currently 10,000 shares outstanding. Ignore taxes for this problem. Assume the stock price is constant.
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.)
Calculate the percentage changes in EPS when the economy expands or enters a recession. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answers as a percent rounded to the nearest whole number, e.g., 32.)
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.)
Given the recapitalization, calculate the percentage changes in EPS when the economy expands or enters a recession. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
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.)
Explanation / Answer
Solution:
a-1) Calculation of EPS before any debt issue
Recession
Normal
Expansion
EBIT
$32,000
$40,000
$48,000
Since there is no debt and no tax EBIT is the Earnings attributable to the Shareholders
$32,000
$40,000
$48,000
No. of Shares outstanding
10000
10000
10000
EPS (Earnings attributable to Shareholders / No of Shares Outstanding)
$3.20
$4.00
$4.80
EPS
Recession
$ 3.20
Normal
$ 4.00
Expansion
$ 4.80
a-2) Calculation of Percentage changes in EPS when the economy expends or enters a recession:
Recession
Normal
Expansion
EPS (as calculated above in part a-1)
$3.20
$4.00
$4.80
Change in EPS from Normal Scenario
-$0.80
$0
$0.80
Percentage Change
(Change in EPS from Normal Scenario / EPS under Normal Scenario)
-20%
0
20%
Percentage Change in EPS
Recession
-20%
Expansion
20%
b-1) Calculation of EPS with recapitalization
Here recapitalization means considering the issuance of debt for repurchase of stock.
We need to know some figures/amount before calculating the EPS.
No of Shares Outstanding before recapitalization = 10,000
Total Market Value = $250,000
Market Value Per Share = $250,000 / 10,000 = $25
Debt Issue = $105,000
Company will repurchase its share at the market value of shares. Hence No. of Shares to be repurchased = $105,000 / $25 = 4,200
No of Shares Outstanding after recapitalization = 10,000 – repurchased share 4,200 = 5,800
Calculation of EPS with recapitalization
Recession
Normal
Expansion
EBIT
$32,000
$40,000
$48,000
Less: Interest on Debt (105,000*4%)
-$4,200
-$4,200
-$4,200
Earnings attributable to shareholders
(since there is no tax, the earnings after interest part is relates to shareholders)
$27,800
$35,800
$43,800
No of Shares Outstanding after recapitalization
5,800
5,800
5,800
EPS (Earrings attributable to Shareholders / No of Shares Outstanding)
$4.79
$6.17
$7.55
EPS
Recession
$ 4.79
Normal
$ 6.17
Expansion
$ 7.55
b-2) Calculation of Percentage changes in EPS
Recession
Normal
Expansion
EPS (as calculated above in part a-1)
$4.79
$6.17
$7.55
Change from Normal Scenario
-$1.38
($4.79 - $6.17)
$0
$1.38
($7.55 - $6.17)
Percentage Change in EPS (Change in EPS from Normal Scenario / EPS under Normal Scenario)
-22.35%
0
22.35%
Percentage Change in EPS
Recession
-22.35%
Expansion
22.35%
Recession
Normal
Expansion
EBIT
$32,000
$40,000
$48,000
Since there is no debt and no tax EBIT is the Earnings attributable to the Shareholders
$32,000
$40,000
$48,000
No. of Shares outstanding
10000
10000
10000
EPS (Earnings attributable to Shareholders / No of Shares Outstanding)
$3.20
$4.00
$4.80
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.