RAK, Inc., has no debt outstanding and a total market value of $240,000. Earning

ID: 2763733 • Letter: R

Question

RAK, Inc., has no debt outstanding and a total market value of $240,000. Earnings before interest and taxes, EBIT, are projected to be $32,000 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. RAK is considering a $80,000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 15,000 shares outstanding. Ignore taxes for this problem.

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

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.)

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.)

Explanation / Answer

EPS normal = EBIT*(1-tax rate)/ shares outstanding

=32000*(1-0.0)/15000

=2.13

EPS recession = EBIT*(1+recession decrease rate)*(1-tax rate)/ shares outstanding

=32000*(1-0.3)*(1-0.0)/15000

=1.49

EPS Expansion = EBIT*(1+expansion increase rate)*(1-tax rate)/ shares outstanding

=32000*(1+0.15)*(1-0.0)/15000

=2.45

Expansion percentage change = (EPS Expansion- EPS normal)*100/ EPS normal

=(2.45-2.13)*100/2.13 = 15.02%

recession percentage change = (EPS recession - EPS normal)*100/ EPS normal

=(1.49-2.13)*100/2.13 = -30.05%

Price per share = MV/shares outstanding

=240000/15000 = 16

Total shares repurchased = debt/share price = 80000/16 = 5000

Total remaining shares = current shares- shares repurchased = 15000-5000 = 10000

EPS normal = (EBIT-debt*interest rate)*(1-tax rate)/ shares outstanding

=(32000-80000*.07)*(1-0.0)/10000

=2.64

EPS recession = (EBIT*(1+recession decrease rate) -debt*interest rate )*(1-tax rate)/ shares outstanding

=(32000*(1-0.3)- 80000*.07)*(1-0.0)/10000

=1.68

EPS Expansion =( EBIT*(1+expansion increase rate) -debt*interest rate )*(1-tax rate)/ shares outstanding

=(32000*(1+0.15)- 80000*.07)*(1-0.00)/10000

=3.12

Expansion percentage change = (EPS Expansion- EPS normal)*100/ EPS normal

=(3.12-2.64)*100/2.64 = 18.18%

recession percentage change = (EPS recession - EPS normal)*100/ EPS normal

=(1.68-2.64)*100/2.64 = -36.36%

FV = PV*(1+r)^n

More the n greater is the (1+r)^n component thus greater is the FV, hence true.

PV = FV/(1+r)^n

Lower the r lower is (1+r)^n greater is FV/(1+r)^n and thus the PV

Hence true

PV = FV/(1+r)^n

greater the greater is (1+r)^n lower is FV/(1+r)^n and thus the PV

Hence true

C future value of lumpsum. John will receive the future value of the lump sum amount invested today after 25 years

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RAK, Inc., has no debt outstanding and a total market value of $240,000. Earning

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RAK, Inc., has no debt outstanding and a total market value of $240,000. Earning

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