Kaelea, Inc., has no debt outstanding and a total market value of $74,000. Earni

Question

Kaelea, Inc., has no debt outstanding and a total market value of $74,000. Earnings before interest and taxes, EBIT, are projected to be $8,100 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 21 percent higher. If there is a recession, then EBIT will be 34 percent lower. Kaelea is considering a $27,400 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 3,700 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. 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. (Do not round intermediate calculations. Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places (e.g., 32.16).)

Calculate earnings per share, EPS, under each of the three economic scenarios after the recapitalization. (Do not round intermediate calculations. 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. (Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places (e.g., 32.16).)

Kaelea, Inc., has no debt outstanding and a total market value of $74,000. Earnings before interest and taxes, EBIT, are projected to be $8,100 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 21 percent higher. If there is a recession, then EBIT will be 34 percent lower. Kaelea is considering a $27,400 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 3,700 shares outstanding. Ignore taxes for this problem.

Explanation / Answer

1a. EPS = Net income/number of shares

EBIT = Net income = 8,100 (as there is no interest and taxes). number of shares = 3,700

EPS in recession = 8100*(1-34%)/3700 = $1.44

EPS in normal = 8100/3700 = $2.19

EPS in expansion = 8100*(1+21%)/3700 = $2.65

b. % change in EPS (compared to normal) when economy is in recession = (2.19-1.44)/2.19 = - 34.00%

% change in EPS (compared to normal) when economy is in expansion = (2.65-2.19)/2.19 = 21.00%

2a. Interest = 7% of 27,400 = $1,918

Net income = EBIT - interest = 8,100 - 1918 = $6,182

EPS in recession = 6182*(1-34%)/3700 = $1.10

EPS in normal = 6182/3700 = $1.67

EPS in expansion = 6182*(1+21%)/3700 = $2.02

b. % change on recession (from normal) = (1.10 - 1.67)/1.67 = - 34.00%

% change in expansion (from normal) = (2.02 - 1.67)/1.67 = 21.00%

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