RAK, Inc., has no debt outstanding and a total market value of $240,000. Earning
ID: 2763758 • 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 $26,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 18 percent higher. If there is a recession, then EBIT will be 20 percent lower. RAK is considering a $150,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 15,000 shares outstanding. RAK has a tax rate of 35 percent.
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. (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. Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
RAK, Inc., has no debt outstanding and a total market value of $240,000. 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 18 percent higher. If there is a recession, then EBIT will be 20 percent lower. RAK is considering a $150,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 15,000 shares outstanding. RAK has a tax rate of 35 percent.
Explanation / Answer
a 1. In present capital structure there is no debt hence EPS = EBIT - Tax/No. of shares
Recession = ($26000 - 20%*26000) - (35%*20800) / 15000 = $.90
Normal = $26000 - (35%*26000) / 15000 = $1.13
Expansion = ($26000 + 18%*26000) - (35%*30680) / 15000 = $.90 = $1.33
a 2. % change = Recession = .90 - 1.13 / 1.13 *100 = -20.35%
Expansion = 1.33 - 1.13 / 1.13 * 100 = 17.70%
b 1. Normal: Earnings after tax = EBIT = $26000
Less Interest = $150000*8%= $12000
EBT = $14000
Less Tax @35% = $4900
EAT = $9100
EPS = $9100/5625 = $1.62
Recession: Earnings after tax = EBIT = $26000 - 20%*26000 = $20800
Less Interest = $150000*8%= $12000
EBT = $8800
Less Tax @35% = $3080
EAT = $5720
EPS = $5720/5625 = $1.02
Expansion: Earnings after tax = EBIT = $26000 + 18%*26000 = $30680
Less Interest = $150000*8%= $12000
EBT = $18680
Less Tax @35% = $6538
EAT = $12142
EPS = $12142/5625 = $2.16
b 2 . % Change = Recession = 1.62 - 1.02 / 1.62 * 100 = 37.04%
Expansion = 1.62 - 2.16 / 1.62 * 100 = -33.33%
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