RAK, Inc., has no debt outstanding and a total market value of $150,000. Earning
ID: 2752310 • Letter: R
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 $28,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 20 percent higher. If there is a recession, then EBIT will be 25 percent lower. RAK is considering a $60,000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 10,000 shares outstanding. Ignore taxes for this problem.
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. (Leave no cells blank - be certain to enter "0" wherever required. 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. 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 $150,000. Earnings before interest and taxes, EBIT, are projected to be $28,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 20 percent higher. If there is a recession, then EBIT will be 25 percent lower. RAK is considering a $60,000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 10,000 shares outstanding. Ignore taxes for this problem.
Explanation / Answer
Part A:
A-1: EPS with no debt & taxes
Under Normal Economic Conditions
EPS = EBIT/shares outstanding = $28,000/10,000 = $2.8
Under Expansionary Times:
EPS = [EBIT x 1.20]/shares outstanding = $28,000(1.2)/10,000 = $3.36
Under Recession Times:
EPS = [EBIT x (1-.25)]/shares outstanding =$28,000(.75)/10,000 = $2.1
A-2: % EPS going from Normal to Expansion:
($3.36 - $2.8)/$2.8 = .2 or 20%
% EPS going from Normal to Recession:
($2.1 - $2.8)/$2.8 = -.25 or -25%
Part B:
If the market value of the firm is $150,000 with 10,000 shares outstanding, then the value of one share of stock is: $150,000/10,000 = $15/share.
If $60,000 worth of debt is raised to retire stock, then you will be buying back $60,000/$15 = 1,000 shares. So, after recapitalization there will be 10,000 - 4,000 = 6,000 shares outstanding.
EBIT will be reduced by the amount of the interest on $60,000 in debt = $60,000 x .07 = $4,200.
Expansion Normal Recession
EBIT $33,600 $28,000 $21,000
Less: Interest $4,200 $4,200 $4,200
EBT=NI $29,400 $23,800 $16,800
EPS $ 4.90 $ 3.97 $ 2.80
% EPS going from Normal to Expansion:
($4.90 - $3.97)/$3.97 = .2342 or 23.42%
% EPS going from Normal to Recession:
($2.8 - $3.97)/$3.97 = -.2947 or -29.47%
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