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

Question

RAK, Inc., has no debt outstanding and a total market value of $150,000. Earnings before interest and taxes, EBIT, are projected to be $32,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 10 percent higher. If there is a recession, then EBIT will be 30 percent lower. RAK is considering a $75,000 debt issue 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 questions a and b. Assume the company has a market-to-book ratio of 1.0.

Explanation / Answer

Earnings per share, EPS, under each of the three economic scenarios before any debt is issued EBIT No.of Shares EPS= EBIT/10000   Recession 32000*(1-0.30)= 22400 10000 2.24   Normal 32000 32000 10000 3.20   Expansion 32000*(1+0.10)= 35200 10000 3.52 Percentage changes in EPS when the economy    % Change Expands (3.52-3.2)/3.2*100= 10 Enters a recession (2.24-3.2)/3.2*100= -30 b. 2      Debt Issue 75000 Repurchased stock 10000/150000*75000 5000 Shares So, O/s shares = 10000-5000= 5000 shares EBIT(Normal) 32000 Less: Int. On Debt 75000*6%= 4500 EBIT(Normal) 27500 NEW Earnings per share, EPS, under each of the three economic scenarios after above debt is issued EBIT No.of Shares EPS= EBIT/5000   Recession 27500*(1-0.30)= 19250 5000 3.85   Normal 27500 27500 5000 5.50   Expansion 27500*(1+0.10)= 30250 5000 6.05 Percentage changes in EPS when the economy    % Change Expands (6.05-5.5)/5.5*100= 10 Enters a recession (3.85-5.5)/5.5*100= -30

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