Pendergast, Inc., has no debt outstanding and a total market value of $140,000.

Question

Pendergast, Inc., has no debt outstanding and a total market value of $140,000. 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 12 percent higher. If there is a recession, then EBIT will be 30 percent lower. Pendergast is considering a $115,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 7,000 shares outstanding. Pendergast has a tax rate of 35 percent.

Pendergast, Inc., has no debt outstanding and a total market value of $140,000. 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 12 percent higher. If there is a recession, then EBIT will be 30 percent lower. Pendergast is considering a $115,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 7,000 shares outstanding. Pendergast 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. (Round your answers to 2 decimal places. (e.g., 32.16)) EPS Recession Normal Expansion 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.) Percentage changes in EPS Recession Expansion b-1 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) EPS Recession Normal Expansion b-2 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)) Percentage changes in EPS Recession Expansion

Explanation / Answer

Answer:

a-1 Calculation of Earnings per Share under different scenarios before debt issue;

Earning per Share (EPS) = Total Earnings after Tax / Total Outstanding Shares

Normal Scenario:

EPS = $ 32,000 - Tax at 35% / 7,000 shares = $ 20,800 / 7,000 = $ 2.97 per share

Recession Scenario:

EPS = $ 32,000 (1 - 0.30) - Tax at 35% / 7,000 shares = $ 14,560 / 7,000 = $2.08 per share

Expanssion Scenario:

EPS = $ 32,000 (1 + 0.12) - Tax at 35% / 7,000 shares = $ 23,296 / 7,000 = $ 3.33 per share.

a-2: Percentage change in EPS:

% Change in EPS = 100 - (EPS under Recession or Expanssion Scenario / EPS under Normal Scenario) x 100

Recession Scenario:

% Change in EPS = 100 - ($ 2.08 / $ 2.97) x 100 = 29.97% decrease

Expanssion Scenario:

% Change in EPS = 100 - ($ 3.33 / $ 2.97) x 100 = 12.12 % increase

b-1 Calculation of Earnings After Tax after Recapitalisation:

In Normal Scenario;

EBIT                                                 = $ 32,000

Less: Interest on Debt Capital             = $ 6,900 (6% of $ 115,000)

EBT                                                  = $ 25,100

Less: Tax at 35%                               = $ 8,785

EAT                                                  = $ 16,315

Number of outatanding Shares = 7,000 shares - ($ 115,000 x $ 140,000 / 7,000) = 1,250 shares after recapitalisation;

Calculation of Earnings per Share under different scenarios after debt issue;

Earning per Share (EPS) = Total Earnings after Tax / Total Outstanding Shares

Normal Scenario:

EPS under Normal Scenarion after Recapitalisation = $ 16,315 / 1,250 shares = 13.05 per share

Recession Scenario:

EPS = {$ 32,000 (1 - 0.30) - $ 6,900} - Tax at 35% / 1,250 shares = $ 10,075 / 1,250 shares = $ 8.06 per share

Expanssion Scenario:

EPS = {$ 32,000 (1 + 0.12) - $ 6,900} - Tax at 35% / 1,250 shares = $ 18,811 / 1,250 shares = $ 15.05 per share

b-2 Percentage change in EPS after Recapitalisation:

% Change in EPS = 100 - (EPS under Recession or Expanssion Scenario / EPS under Normal Scenario) x 100

Recession Scenario:

% Change in EPS = 100 - ($ 8.06 / $ 13.05) x 100 = 38.24% decrease

Expanssion Scenario:

% Change in EPS = 100 - ($ 15.05 / $ 13.05) x 100 = 15.33 % increase.

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