Pendergast, Inc., has no debt outstanding and a total market value of $150,000.

Question

Pendergast, Inc., has no debt outstanding and a total market value of $150,000. 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 12 percent higher. If there is a recession, then EBIT will be 20 percent lower. Pendergast is considering a $90,000 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. 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

a.1 Calculate earnings per share [EPS] under each of the three economic scenarios before any debt is issued.

If 35% taxe rate and there is no debt outstanding:

Under Normal Economic Conditions EPS = EBIT/shares outstanding = $26,000(1-0.35)/10,000 = $1.69

Under Expansionary Times: EPS = [EBIT x 1.12] (1-0.35)/shares outstanding = $26,000(1.12) (1 - 0.35/10,000 =$1.8928

Under a Recession: EPS = [EBIT x (1-.20) ( 1-0.35) ]/shares outstanding =$26,000(.80)(1-0.35)/10,000 = $1.352

a.2) Percentage of Change in EPS:

Under Recession:

%EPS = (1.352 - 1.69)/1.69 = -20%

Under Expansion

%EPS = (1.8928 - 1.69)/ = 12%

b-1) Computation of EPS, when the Company goes for recapitaliation:

If the firm goes forward with recapitalization, the new equity value will be: Equity = $150,000 - $90,000 or $60,000 [due to reduction of shares outstanding]

**If $90,000 worth of debt is raised to retire stock, then you will be buying back $90,000/$15 or 6,000 shares. So, after recapitalization there will be 10,000 -  6,000 or 4,000 shares outstanding.
b-2) Percentage of Change in EPS:

under Recession

%EPS = (2.5025 - 3.3475)/3.3475 = -25.24%

Under Expansion:

%EPS= (3.8545 - 3.3475)/3.3475 = 15.15%

Normal Expansion Recission EBIT $ 26,000 29,120 20,800 Lesss: Interest (6%) $ 5,400 5,400 5,400 EBT $ 20,600 23,720 15,400 Less : Taxes @ 35% $ 7,210 8,302 5,390 Net Income $ 13,390 15,418 10,010 No of shares** 4,000 4,000 4,000 EPS = NI/No. of Shares outstandig $ 3.3475 3.8545 2.5025

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