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EBIT and Leverage. Kaelea, Inc., has no debt outstanding and a total market valu

ID: 2650013 • Letter: E

Question

EBIT and Leverage. Kaelea, Inc., has no debt outstanding and a total market value of $125,000. Earnings before interest and taxes, EBIT, are projected to be $10,400 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 20 percent higher. If there is a recession, then EBIT will be 35 percent lower. Kaelea is considering a $42,000 debt issue with a 6 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 6,250 shares outstanding. Ignore taxes for this problem.
a. Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is issued. Also, calculate the percentage changes in EPS when the economy expands or enters a recession.
b. Repeat part (a) assuming that Kaelea goes through with recapitalization. What do you observe?

Explanation / Answer

a. Normal Economic Condition

EBIT=10400

Earning after tax and interest=10400-0-0 =$ 10400

No of shares=6250

Earning per share=10400/6250= $ 1.664

Strong Expension

EBIT=10400*120%=12480

Earning after tax= 12480

EPS=12480/6250=2.00

percentage change=2-1.66/1.66=20% increase

Recession

EBIT=10400*65%=6760

EPS=6760/6250=1.08

Decrease in EPS=1.08-1.66/1.66=35% decrease

b. Recapitalisation

New EAT=EBIT-interest =10400-42000*6%=7880

Market Price of 6250 shares is 125000

MPS=125000/6250=$20

No of shares purchased=42000/20=2100

Shares Outstanding=6250-2100=4150

EPS=7880/4150= $1.90

Increase in EPS=1.90-1.66/1.66= 15%