RAK, Inc., has no debt outstanding and a total market value of $240,000. Earning
ID: 2791043 • 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 $28,000 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 25 percent lower. RAK is considering a $48,000 debt issue with an interest rate of 4 percent. The proceeds will be used to repurchase shares of stock. There are currently 20,000 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.)
RAK, Inc., has no debt outstanding and a total market value of $240,000. Earnings before interest and taxes, EBIT, are projected to be $28,000 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 25 percent lower. RAK is considering a $48,000 debt issue with an interest rate of 4 percent. The proceeds will be used to repurchase shares of stock. There are currently 20,000 shares outstanding. Ignore taxes for this problem.
Explanation / Answer
EBIT under normal condition = 28,000
EBIT under expansion condition = 28,000 * 1.1 = 30,800
EBIT under recession condition = 28,000 * 0.75 = 21,000
Interest and Taxes will be 0
Shares Outstanding = 20,000
EPS under normal condition = 28,000/ 20,000 = 1.40
EPS under expansion condition = 30,800/ 20,000 = 1.54
EPS under recession condition = 21,000/ 20,000 = 1.05
Part A - 2
%change in EPS when recession occurs = (1.05 - 1.40)/ 1.40 = -25%
%change in EPS when expansion occurs = (1.54 - 1.40)/ 1.40 = 10%
Part B
If the company undergoes the proposed recapitalization, it will repurchase:
Share price = Equity / Shares outstanding
Share price = $240,000 / 20,000
Share price = $12
Shares repurchased = Debt issued / Share price
Shares repurchased = $48,000 / $12
Shares repurchased = 4,000
The interest payment each year under all three scenarios will be:
Interest payment = $48,000 * (0.04) = $1,920
NI under normal condition = 28,000 - 1,920 = 26,080
NI under expansion condition = 30,800 - 1,920 = 28,880
NI under recession condition = 21,000 - 1,920 = 19,080
Shares Outstanding = 20,000 - 4,000 = 16,000
EPS under normal condition = 26,080/ 16,000 = 1.63
EPS under expansion condition = 28,880/ 16,000 = 1.81
EPS under recession condition = 19,080/ 16,000 = 1.19
Part B - 2
%change in EPS when recession occurs = (1.19 - 1.63)/ 1.63 = -26.84%
%change in EPS when expansion occurs = (1.81 - 1.63)/ 1.63 = 10.74%
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