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

Question

RAK, Inc., has no debt outstanding and a total market value of $220,000. Earnings before interest and taxes, EBIT, are projected to be $42,000 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 30 percent lower. RAK is considering a $66,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 10,000 shares outstanding. Ignore taxes for this problem.

Calculate earnings per share (EPS) under each of the three economic scenarios before any debt is issued.

recession____

normal_____

expansion_____

Calculate the percentage changes in EPS when the economy expands or enters a recession

Recession_____

expansions_____

Calculate earnings per share (EPS) under each of the three economic scenarios assuming the company goes through with recapitalization.

normal_____

recession_____

expansion_____

Given the recapitalization, calculate the percentage changes in EPS when the economy expands or enters a recession

Recession________

expansion________

RAK, Inc., has no debt outstanding and a total market value of $220,000. Earnings before interest and taxes, EBIT, are projected to be $42,000 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 30 percent lower. RAK is considering a $66,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 10,000 shares outstanding. Ignore taxes for this problem.

Explanation / Answer

a. Normal EPS = $42,000 / 10,000

= $4.20

Expansion EPS = $42,000 * (1+20%) / 10,000

= $5.04

Recession EPS = $42,000 * (1-30%) / 10,000

= $2.94

b. After recapitalization,

No. of outstanding shares = 10,000 - $66,000 / $220,000 * 10,000

= 7,000

Normal EBT = $42,000 - 6% * $66,000

= $38,040

So, Normal EPS = $38,040 / 7,000

= $5.43

Expansion EBT = $42,000 * (1+20%) - 6% * $66,000

= $46,440

So, Expansion EPS = $46,440 / 7,000

= $6.63

Recession EBT = $42,000 * (1-30%) - 6% * $66,000

= $25,440

So, Recession EPS = $25,440 / 7,000

= $3.63

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