RAK, Inc., has no debt outstanding and a total market value of $220,000. Earning

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

Without any debt Particulars Normal Expansion Recession EBIT                    40,000                        44,000                    32,000 Less: Interest                              -                                    -                               -   EBT                    40,000                        44,000                    32,000 Less: Tax @ 35%                    14,000                        15,400                    11,200 Earning for equity                    26,000                        28,600                    20,800 Number of shares                    11,000                        11,000                    11,000 EPS                         2.36                             2.60                         1.89 % Change in EPS 10% -27% With debt Particulars Normal Expansion Recession EBIT                    40,000                        44,000                    32,000 Less: Interest                       5,400                           5,400                      5,400 EBT                    34,600                        38,600                    26,600 Less: Tax @ 35%                    12,110                        13,510                      9,310 Earning for equity                    22,490                        25,090                    17,290 Number of shares                       4,250                           4,250                      4,250 EPS                         5.29                             5.90                         4.07 % Change in EPS 12% -31%

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