RAK, Inc., has no debt outstanding and a total market value of $220,000. Earning
ID: 2733788 • Letter: R
Question
RAK, Inc., has no debt outstanding and a total market value of $220,000. Earnings before interest and taxes, EBIT, are projected to be $40,000 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 20 percent lower. RAK is considering a $135,000 debt issue with an interest rate of 4 percent. The proceeds will be used to repurchase shares of stock. There are currently 11,000 shares outstanding. RAK has a tax rate of 35 percent.
Calculate earnings per share (EPS) under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations and 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. Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
Calculate earnings per share (EPS) under each of the three economic scenarios assuming the company goes through with recapitalization. (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)
Given the recapitalization, calculate the percentage changes in EPS when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
RAK, Inc., has no debt outstanding and a total market value of $220,000. Earnings before interest and taxes, EBIT, are projected to be $40,000 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 20 percent lower. RAK is considering a $135,000 debt issue with an interest rate of 4 percent. The proceeds will be used to repurchase shares of stock. There are currently 11,000 shares outstanding. RAK has a tax rate of 35 percent.
Explanation / Answer
Solution.
If you ignore taxes in this problem and there is no debt outstanding:
Under Normal Economic Conditions
EPS = EBIT / shares outstanding
= $40,000 / 11,000
= $3.63
Under Expansionary Times:
EPS = [ EBIT x 1.10 ] / shares outstanding
= $40,000 (1.1) / 11,000
= $44,000 / 11,000
= $4.00
Under a Recession:
EPS = [EBIT x (1-.20 ) ] / shares outstanding
=$40,000 ( .80 ) / 11,000
= $32,000 / 11,000
= $2.90
% EPS going from Normal to Expansion:
($4.00 - $3.63) / $3.63 = .10 or 10%
% EPS going from Normal to Recession:
($2.90 - $3.63) / $3.63 = -.20 or -.20%
B1.Calculation of earnings per share (EPS) under each of the three economic scenarios assuming the company goes through with recapitalization.
When market value of firm = 220,000.
Share outstanding = 11,000
Share value = 220,000 / 11,000 = $20
If RAK is considering a $135,000 debt issue.
Than buy back of share = $135,000 / $20 = 6,750 share.
Remain outstanding share = 11,000 - 6,750 = 4,250.
Interest on debt = $135,000 x 4% = $5,400
% EPS going from Normal to Expansion:
($9.08 - $8.14) / $8.14 = .11 or 11%
% EPS going from Normal to Recession:
($6.26 - $8.14) / $8.14 = -.23 or -.23%
Recession Normal Expansion EBIT 32,000.00 40,000.00 44,000.00 Interest 5,400.00 5,400.00 5,400.00 EBT =NI 26,600.00 34,600.00 38,600.00 Share Outstanding 4250 4,250 4,250 EPS 6.26 8.14 9.08Related Questions
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