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.

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. (Leave no cells blank - be certain to enter "0" wherever required. 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. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

Percentage changes in EPS

Recession_____ %

Expansion______ %

Explanation / Answer

a-1) EPS before any dabt is issued: recession normal expansion EBIT 29400 42000 50400 no of shares outstanding 10000 10000 10000 EPS 2.94 4.20 5.04 a-1) % change in EPS when economy changes: Change in % -30.00% 20.00% b-1) EPS with recapitalization: recession normal expansion EBIT 29400 42000 50400 interest on debt(66000*0.06) 3960 3960 3960 net income 25440 38040 46440 no of shares outstanding 7000 7000 7000 EPS 3.63 5.43 6.63 b-2) % change in EPS when the economy changes: Change in % -33.12% 22.08%

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