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

Question

Beckett, 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. Beckett 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. Ignore taxes for questions a and b. Assume the company has a market-to-book ratio of 1.0.

Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places (e.g., 32.16).)

Calculate the percentage changes in ROE 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.)

Calculate the return on equity (ROE) under each of the three economic scenarios. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places (e.g., 32.16).)

Calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations and round your final answers to 2 decimal places (e.g., 32.16).)

Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places (e.g., 32.16).)

Calculate the percentage changes in ROE 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.)

Calculate the return on equity (ROE) under each of the three economic scenarios assuming the firm goes through with the recapitalization. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places (e.g., 32.16).)

Given the recapitalization, calculate the percentage changes in ROE 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 return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places (e.g., 32.16).)

Explanation / Answer

a-1. EPS, under each of the three economic scenarios before any debt is issued

EPS Recession (40000*.80/11000) = $2.91

EPS Normal (40000/11000) = $3.64

EPS Expansion (40000*1.10/11000) = $4.00

a-2. Percentage changes in EPS

Recession % = -20.54%

Expansion % = 9.89%

b-1. EPS under each of the three economic scenarios assuming the company goes through with recapitalization :

Share price = Equity / Shares outstanding
Share price = $220,000/11,000
Share price = $20
Shares repurchased = Debt issued / Share price
Shares repurchased =$(135,000/20)
Shares repurchased = 6,750
The interest payment each year under all three scenarios will be:
Interest payment = $135,000(.04) = $5,400

EPS Recession {$(40000*.80) - $5,400} / 4250 = $6.26

EPS Normal {$40000 - $5,400} / 4250 = $8.14

EPS Expansion {$(40000*1.10) - $5,400} / 4250 = $9.08

b-2. Percentage changes in EPS when the economy expands or enters a recession

Recession % = -23.10%

Expansion % = 11.55%

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