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

Question

Pendergast, Inc., has no debt outstanding and a total market value of $250,000. Earnings before interest and taxes, EBIT, are projected to be $42,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 18 percent higher. If there is a recession, then EBIT will be 30 percent lower. Pendergast is considering a $100,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 10,000 shares outstanding. Pendergast has a tax rate of 35 percent.

  

Calculate earnings per share (EPS) under each of the three economic scenarios before any debt is issued. (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.)

  

  

Assume that the company goes through with recapitalization. Calculate earnings per share (EPS) under each of the three economic scenarios assuming the company goes through with recapitalization. (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. Round your answers to 2 decimal places. (e.g., 32.16))

  

Pendergast, Inc., has no debt outstanding and a total market value of $250,000. Earnings before interest and taxes, EBIT, are projected to be $42,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 18 percent higher. If there is a recession, then EBIT will be 30 percent lower. Pendergast is considering a $100,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 10,000 shares outstanding. Pendergast has a tax rate of 35 percent.

Explanation / Answer

Answer)

EPS = Net Income / Number of share

EPS of Normal economy= 27300/10000 =2.73

EPS of Recession = 19110/10000 =1.911

EPS of Expansion = 32214 / 10000 = 3.22

Answer a-2

Percentage changes in EPS

Recession = (1.911-2.73) / 2.73 = -30% (decrease of 30%)

Expansion = (3.2214 - 2.73) / 2.73 = 18% (Increase of 18%)

Answer b-1) When debt is used to repurchase stocks

35%*41560 = 14546

Now the number of shares we repurchase using debt

Share price = 250000/10000 =25

Number of shares repurchased with debt of 100000 = 100000/25 = 4000

Number of outstanding shares left = 10000-4000 = 6000

EPS now

Normal economy = 22100/6000 = 3.68

Recession = 13910/6000 = 2.32

Expansion = 27014/6000 = 4.5

Answer b-2

Percentage change

Recession = (2.32-3.68)/3.68 = -37.06%

Expansion = (4.5-3.68)/3.68 = 22.24%

Normal Recession Expansion EBIT 42000 42000*(1-0.30) = 29400 42000*(1.18) = 49560 -Interest 0 0 0 EBT 42000-0 = 42000 29000-0 =29000 49560-0 =49560 -Taxes 35%*42000=14700 35%*29400 = 10290 35%*49560=17346 Net Income 42000-14700=27300 29000-10290 = 19110 49560-17346=32214

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