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. a-1 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.) EPS Recession $ Normal $ Expansion $ a-2 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.) Percentage changes in EPS Recession -20 % Expansion 10 % b-1 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.) EPS Recession $ Normal $ Expansion $ b-2 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.) Percentage changes in EPS Recession % Expansion 11.56 %

Explanation / Answer

a-1& a-2    Current -Only Equity& No Debt Normal Expansion Recession EBIT 40000 44000 32000 Tax @ 35% 14000 15400 11200 EAT 26000 28600 20800 No.of shares o/s 11000 11000 11000 EPS 2.36 2.6 1.89 % change in EPS (2.6-2.36)/2.36*100 (1.89-2.36).2.36*100 10.17 -19.92 Market Value of firm 220000 Shares o/s 11000 Value/share220000/11000 20 Debt to be raised 135000 So, buy-back @ 20 /share 135000/20 6750 Shares So.after issuing debt or recapitalisation, No.of shares O/s will be 11000-6750= 4250 Interest on debt will be 135000*4% EBIT will be reduced by 5400 b-1 & b-2   Proposed - Equity & $ 135000 Debt Normal Expansion110%*Normal Recession80%*Normal EBIT 40000 44000 32000 Interest on Debt 5400 5400 5400 EBT 34600 38600 26600 Tax @ 35% 12110 13510 9310 EAT 22490 25090 17290 No.of shares o/s 4250 4250 4250 EPS 5.29 5.90 4.07 % change in EPS (5.90-5.29)/5.29*100 (4.07-5.29)/5.29*100 11.53 -23.06

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