RAK, Inc., has no debt outstanding and a total market value of $240,000. Earning

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 $36,000 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 25 percent lower. RAK is considering a $155,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 6,000 shares outstanding. RAK has a tax rate of 35 percent. 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 A A 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 -25 % Expansion 20 % b-1 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.) EPS Recession Normal A A A Expansion

Explanation / Answer

Answer a-1)

EPS = Net income/ number of shares

EPS in normal economy = 23400/6000 = 3.9

EPS in strong economy = 28080 / 6000 = 4.68

EPS in Recession = 17550 / 6000 = 2.93

Answer b-1)

Now since debt has been used to repurchase shares out number of outstanding shares will reduce,

Price of each share = Market value / Intial outstanding shares = 240000/6000 = 40

Number of shares repurchased by using debt of 155000 = 155000/40 = 3875

Now outstanding shares left in the market = 6000- 3875 = 2125

EPS = Net Income / Number of shares after repurchase

Normal economy = 17355/2125 =8.17

Strong economy = 22035 /2125 =10.37

Recession = 11505/2125 = 5.41

Normal Economy Strong Economy Recession EBIT 36000 36000*(1.20) = 43,200 36000*(1-0.25) = 27000 - Interest 0 0 0 EBT 36000-0=36000 43200-0=43200 27000-0=27000 -Taxes 35%*36000 = 12,600 35%*43200 = 15120 35%*27000 = 9450 Net Income 36000-12000 = 23400 43200-15120 = 28080 27000-9450=17550

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