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Kaelea, Inc., has no debt outstanding and a total market value of $82,000. Earni

ID: 2719759 • Letter: K

Question

Kaelea, Inc., has no debt outstanding and a total market value of $82,000. Earnings before interest and taxes, EBIT, are projected to be $8,500 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 $28,200 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 4,100 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 $82,000. Earnings before interest and taxes, EBIT, are projected to be $8,500 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 $28,200 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 4,100 shares outstanding. Ignore taxes for this problem.

Explanation / Answer

Answer:

1 (a) Calculation of Earnings Per Share (before any debt is issued)

Note: In the given case, EBIT is the Earnings Available to Equity Shareholders because taxes ignored.

1 (b). Calculation of percentage changes in EPS when the economy expands or enters a recession

Percetange Change in EPS when economy enters a Recession = Change in EPS from Normal Condition / EPS under normal condition x 100 = ($2.07 - $1.35) / $2.07 x 100 = $0.72 / $2.07 x 100 = -34.78% (approx.) or -35% exactly

Percetange Change in EPS when economy expands = Change in EPS from Normal Condition / EPS under normal condition x 100 = ($2.49 - $2.07) / $2.07 x 100 = $0.42 / $2.07 x 100 = +20.29% (Approx) or 20% Exactly

2. Calculation of earnings per share, EPS, under each of the three economic scenarios after the recapitalization

Note 2:

Market Price per Share before repurchase = $82,000 / 4,100 = $20

No. of Shares repurchased from proceeds of Debt = $28,200 / $20 = 1,410 Shares

No. of Shares Outstanding after recapitalization = 4,100 - 1,410 = 2,690 Shares

2(b) Calculation of percentage changes in EPS when the economy expands or enters a recession

Percetange Change in EPS when economy enters a Recession = Change in EPS from Normal Condition / EPS under normal condition x 100 = ($2.43 - $1.32) / $2.43 x 100 = $1.11 / $2.43 x 100 = -45.68%

Percetange Change in EPS when economy expands = Change in EPS from Normal Condition / EPS under normal condition x 100 = ($3.06 - $2.43) / $2.43 x 100 = $0.63 / $2.43 x 100 = +25.93%

Particulars Amount (US$) Recession Normal Expansion Earning Before Interest and Taxes $5,525 $8,500 $10,200 No. of Shares Outstanding 4,100 4,100 4,100 Earnings Per Share = Earnings Available to Equity Shareholders / No. of Shares Outstanding $1.35 $2.07 $2.49