Music City, Inc., has no debt outstanding and a total market value of $150,000.
ID: 2805461 • Letter: M
Question
Music City, Inc., has no debt outstanding and a total market value of $150,000. Earnings before interest and taxes, EBIT, are projected to be $32,000 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 30 percent lower. The company is considering a $75,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 10,000 shares outstanding. Ignore taxes for this problem. Assume the stock price is constant.
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. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answers as a percent rounded to the nearest whole number, e.g., 32.)
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.)
Given the recapitalization, calculate the percentage changes in EPS when the economy expands or enters a recession. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
Music City, Inc., has no debt outstanding and a total market value of $150,000. Earnings before interest and taxes, EBIT, are projected to be $32,000 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 30 percent lower. The company is considering a $75,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 10,000 shares outstanding. Ignore taxes for this problem. Assume the stock price is constant.
Explanation / Answer
a1. EPS before debt is issued:
Recession 32000*(1-0.30) = 22400/10000 = 2.24
normal 32000/10000 = 3.2
Expansion 32000*(1.1) = 35200/10000 = 3.52
a2.
recession = (2.24-3.2)/3.2 = -30%
Expand = (3.52 - 3.2)/3.2 = 10%
b1.
Total market value = 150000
Number of shares = 10000
Price per share = 15
Total debt = 75000
Number of shares repurchased by debt = 75000/15 = 5000
Now shares remaning = 10000 - 5000 = 5000
Interest on debt = 75000*6% = 4500
Recession
(EBIT as above) 22400 - 4500 = 17900
EPS = 17900/5000 = 3.58
Normal
EBIT 32000 - Interest 4500 = 27500
EPS = 27500/5000 = 5.5
Expansion
(EBIT as above) 35200 - 4500 = 30700
EPS = 30700/5000 = 6.14
b2
% change in EPS
Recession = (3.58-5.5)/5.5 = -34.90%
Expansion = (6.14 - 5.5)/5.5 = 11.64%
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.