Beckett, Inc., has no debt outstanding and a total market value of $150,000. Ear

Question

Beckett, Inc., has no debt outstanding and a total market value of $150,000. Earnings before interest and taxes, EBIT, are projected to be $26,000 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 20 percent lower. Beckett is considering a debt issue of $90,000 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.

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 final answers to 2 decimal places (e.g., 32.16).)

Calculate the percentage changes in EPS when the economy expands or enters a recession. (Do not round intermediate calculations. Negative amounts should be indicated by a minus sign. Enter your answers as a percent.)

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 final 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. Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places (e.g., 32.16).)

Beckett, Inc., has no debt outstanding and a total market value of $150,000. Earnings before interest and taxes, EBIT, are projected to be $26,000 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 20 percent lower. Beckett is considering a debt issue of $90,000 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.

Explanation / Answer

Part A:

The formula for calculating EPS under normal economic conditions would be:

Earning Per Share = EBIT/Total Shares Outstanding

The formula for calculating EPS under expansionary economic conditions would be:

Earning Per Share = EBIT*(1+Growth%)/Total Shares Outstanding

The formula for calculating EPS under recession would be:

Earning Per Share = EBIT*(1-Decline%)/Total Shares Outstanding

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Using the value provided in the question, we get,

EPS (Recession) = $26,000*(1-20%)/10,000 = $2.08

EPS (Normal) = $26,000/10,000 = $2.60

EPS (Expansion) = $26,000*(1+12%)/10,000 = $2.91

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Part b)

The formula for calculating % change in EPS from Normal to Expansion is:

% Change in EPS = (EPS Under Expansion - EPS Under Normal Conditions)/EPS Under Normal Conditions*100

The formula for calculating % change in EPS from Normal to Recession is:

% Change in EPS = (EPS Under Recession - EPS Under Normal Conditions)/EPS Under Normal Conditions*100

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Using the values calculated in part a) in the above formula, we get,

% Change in EPS (Recession) = (2.08 - 2.60)/2.60*100 = -20%

% Change in EPS (Expansion) = (2.91 - 2.60)/2.60*100 = 12%

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Part c)

We will have to calculate the revised EBIT and the revised number of outstanding shares. Currently, the market value of 1 share of stock is $15 ($150,000/10,000). If we have to raise debt of $90,000 in order to retire stock, we will have to buy back 6,000 shares ($90,000/15). Therefore, the number of shares outstanding after recapitalization would be 4,000 (10,000 - 6,000) shares.

EBIT under each scenario would get adjusted for the interest amount of $5,400 on debt of $90,000.

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Using the value provided in the question, we get,

EPS (Recession) = (26,000*(1-20%) - 5,400)/4,000 = $3.85

EPS (Normal) = (26,000 - 5,400)/4,000 = $5.15

EPS (Expansion) = (26,000*(1+12%) - 5,400)/4,000 = $5.93

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Part d)

Again using the formulas mentioned in part b) and using the values calculated in part c), we get,

% Change in EPS (Recession) = (3.85 - 5.15)/5.15*100 = -25.24%

% Change in EPS (Expansion) = (5.93 - 5.15)/5.15*100 = 15.15%

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