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 $40,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 10 percent higher. If there is a recession, then EBIT will be 20 percent lower. RAK is considering a $135,000 debt issue with an interest rate of 4 percent. The proceeds will be used to repurchase shares of stock. There are currently 11,000 shares outstanding. Ignore taxes for this problem.

Explanation / Answer

Solution:if you ignore taxes in this problem and there is no debt outstanding.
Under Normal Economin Conditions
EPS = EBIT/shares outstanding
=$ 40,000/11,000
=$ 3.64
Under Expansionary Times:
EPS=(EBIT*1.20)/shares outstanding
=$40,000(1.1)/11,000
$4
Under a Recession:
EPS=EBIT*(1-.20)/shares outstanding
=$ 40,000(0.80)/11,000
=$2.91
% EPS going from Normal Expansion:
($4-$3.64)/$3.64
=0.98 or 98%
% EPS going from Normal Recession:
=($2.91-$3.64)/$3.64
=-.20 or -20%

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