Jagdambay Exports has no debt outstanding and a total market value of $180,000.
ID: 2658254 • Letter: J
Question
Jagdambay Exports has no debt outstanding and a total market value of $180,000. Earnings before interest and taxes, EBIT, are projected to be $23,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 20% higher. If there is a recession, then EBIT will be 30% lower. Jagdambay Exports is considering a $75,000 debt issue with a 7% interest rate. The proceeds will be used to repurchase shares of stock. There are currently 6,000 shares outstanding. The tax rate is 35%. Based on the given information, please answer questions a and b.
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 the company goes through with recapitalization. What do you observe?
Explanation / Answer
a)
Normal Condition:
EPS = EBIT*(1-Tax rate)//No. of Shares = 23000*(1-0.35)/6000 = $2.49167
Expansion Condition:
EPS = EBIT*(1-Tax rate)//No. of Shares = 23000*1.2*(1-0.35)/6000 = $2.99
% change = (2.99-2.49167)/2.49167 = 20%
Recession Consition:
EPS = EBIT*(1-Tax rate)//No. of Shares = 23000*(1-0.3)*(1-0.35)/6000 = $1.744167
% change = (1.744167-2.49167)/2.49167 = -30%
b)
No. of Shares Repurchased = 75000/ (180000/6000) = 2500
No. of Shares Remaining = 6000 - 2500 = 3500
Interest Cost (same for all conditions) = 0.07*75000 = $5250
Normal Condition:
EPS = (EBIT-Interest)*(1-Tax rate)//No. of Shares = 17750*(1-0.35)/3500 = $3.2964
Expansion Condition:
EPS = (EBIT-Interest)*(1-Tax rate)//No. of Shares = (1.2*23000-5250)*(1-0.35)/3500 = $4.1507
% change = (4.1507-3.2964)/3.2964 = 25.92%
Recession Consition:
EPS = (EBIT-Interest)*(1-Tax rate)//No. of Shares = (0.7*23000-5250)*(1-0.35)/3500 = $2.015
% change = (2.015-3.2964)/3.2964 = -38.87%
We see that EPS increased for Normal condition as we introduce debt in the capital structure. Also the % changes in Expansion & Recession magnifies as debt is increased.
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