Kaelea, Inc., has no debt outstanding and a total market value of $100,000. Earn

Question

Kaelea, Inc., has no debt outstanding and a total market value of $100,000. Earnings before interest and taxes, EBIT, are projected to be $8,400 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 24 percent higher. If there is a recession, then EBIT will be 31 percent lower. Kaelea is considering a $35,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 4,000 shares outstanding. Assume Kaelea 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. 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. (Do not round intermediate calculations. Negative amounts should be indicated by a minus sign.)

Calculate earnings per share, EPS, under each of the three economic scenarios after the recapitalization. (Do not round intermediate calculations. 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. (Do not round intermediate calculations. Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places (e.g., 32.16).)

Kaelea, Inc., has no debt outstanding and a total market value of $100,000. Earnings before interest and taxes, EBIT, are projected to be $8,400 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 24 percent higher. If there is a recession, then EBIT will be 31 percent lower. Kaelea is considering a $35,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 4,000 shares outstanding. Assume Kaelea has a tax rate of 35 percent.

Explanation / Answer

Under Normal Economic Conditions:

EPS = EBIT/shares outstanding = $8,400 * (1 - 35%) / 4,000 = $1.37

Under Expansionary Conditions:

EPS = EBIT/shares outstanding = $8,400 * 1.24 * (1 - 35%)/ 4,000 = $1.69

Under Recession Conditions:

EPS = EBIT/shares outstanding = $8,400 * 0.69 * (1 - 35%)/ 4,000 = $0.94

Part B:

% EPS change after going from normal to expansion = (1.69 - 1.37)/ 1.37

% EPS change after going from normal to expansion = 24%

% EPS change after going from normal to recession = (0.94 - 1.37)/ 1.37

% EPS change after going from normal to recession = -31%

Part 2:

Market Value = 100,000

Shares outstanding = 4,000

Market Price = 100,000/ 4,000

Market Price = 25

If 35,000 debt is issued, then buyback of shares will be = 35,000/25

If 35,000 debt is issued, then buyback of shares will be = 1,400

Number of Shres Outstandin = 4,000 - 1,400 = 2,600

EBIT will be reduced by interest amount = 35,000 * 0.06 = 2,100

Normal:

Net Income = (8,400 - 2,100) * 0.65

Net Income = 4,095

EPS = 4,095/ 2,600

EPS = 1.58

Expansionary:

Net Income = (8,400 * 1.24 - 2,100) * 0.65

Net Income = 5,405.40

EPS = 5,405.40/ 2,600

EPS = 2.08

Recession:

Net Income = (8,400 * 0.69 - 2,100) * 0.65

Net Income = 2,402.40

EPS = 2,402.40/ 2,600

EPS = 0.92

% change in EPS going from normal to expansion = (2.08 - 1.58)/ 1.58 = 32.00%

% change in EPS going from normal to recession = (0.92 - 1.58)/ 1.58 = -70.45%

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