RAK, Inc., has no debt outstanding and a total market value of $250,000. Earning

Question

RAK, Inc., has no debt outstanding and a total market value of $250,000. 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 20 percent higher. If there is a recession, then EBIT will be 20 percent lower. RAK is considering a $105,000 debt issue with an interest rate of 4 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 "o" 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

Net Income or Earnings: NI = (EBIT – Interest)*(1 – T)

EPS = Earnings/Outstanding Shares

a:

When Tax = 0 and debt = 0, Earnings = EBIT; therefore, % change in EPS equals % change in Earnings.

Shares outstanding = 10,000

Stock price = 250,000/10,000 = $25

b:

Debt = $105,000

Equity = 250,000 – 105,000 = 145,000

Outstanding shares = 145,000/25 = 5800

Interest = 105,000*0.04 = 4200

Earnings = EBIT - Interest

EPS = (EBIT – Interest)/ Outstanding shares (ignoring taxes)

EPS = EBIT/ Outstanding shares

EPS / EPS = EBIT/(EBIT – Interest)

%EPS = %EBIT(1 – Interest/EBIT) = 20/(1 – 4200/40000) = 22.35%

Given the scenario, when EBIT changes by 20%, EPS changes by 22.35%

Below are the tables containing calculation.

% change in EPS = (EPS final case / EPS normal case) – 1

Without Debt Recession Normal Expansion EBIT 32000 40,000 48000 NI 32000 40000 48000 EPS 3.20 4.00 4.80 %EPS -20.00% 20.00%

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