Music City, Inc., has no debt outstanding and a total market value of $180,000.

Question

Music City, Inc., has no debt outstanding and a total market value of $180,000. Eamings before interest and axes, EBIT, are projected to be $25,000 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. The company is considering a $60,000 debt issue with an interest rate of 5 percent. The proceeds will be used to repurchase shares of stock. There are currenty 6,000 shares outstanding. Ignore taxes for this problem. Assume the stock price is constant. 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.) Recession Normal Expansion EPS $ 3.33 $ 4.17 4,580 a-2. Calculate the percentage changes in EPS when the economy expands or enters a recession (A te calculations and enter your answers as a percent rounded to the nearest whole number, e.g., 32 Percentage changes in EPS Recession Expansion 100% :20 096 company goes through with recapitalization. (Do not round intermediate calculations and round your answers to 2 decimal places, e.g. 32.16.) b-1. Calculate earnings per share (EPS) under each of the three economic scenarios assuming the EPS Recessiorn Norma s3.40 on 5 4.90 0

Explanation / Answer

a-1) Recession Normal Expansion EBIT 20000 25000 27500 Number of shares 6000 6000 6000 EPS $          3.33 $          4.17 $           4.58 a-2) Percentage change in EPS Recession = (3.33-4.17)/4.17 = -20% Expansion = (4.58-4.17)/4.58 = 9% b-1) Recession Normal Expansion EBIT 20000 25000 27500 Interest = $60000*5% = 3000 3000 3000 Net income 17000 22000 24500 Number of shares 4000 4000 4000 EPS 4.25 5.50 6.13 CALCULATION OF NUMBER OF SHARES AFTER RECAPITALIZATION: Value of one share = 180000/6000 = $30 Shares repurchased = 60000/30 = 2000 Remaining shares = 6000-2000 = 4000 b-2) Percentage change in EPS Recession = (4.25-5.50)/5.50 = -23% Expansion = (6.13-5.50)/5.50 = 11%

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