AK, Inc., has no debt outstanding and a total market value of $150,000. Earnings

Question

AK, Inc., has no debt outstanding and a total market value of $150,000. Earnings before interest and taxes, EBIT, are projected to be $36,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 15 percent higher. If there is a recession, then EBIT will be 25 percent lower. RAK is considering a $95,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 6,000 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 % Expansion % 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 %

Explanation / Answer

EBIT Percentage Expected EBIT Shares Outstanding EPS= Expected EBIT/Shares Outstanding Recession $36,000 15.00% $41,400 6000 $6.90 Normal $36,000 0.00% $36,000 6000 $6.00 Expansion $36,000 -25.00% $27,000 6000 $4.50 a-2 Calculate the percentage changes in EPS when the economy expands or enters a recession. Recession = ($6 -$6.90)/$6 -15.00% Expansion = ($6 - $4.50)/$6 25.00% b-1 Assume that the company goes through with recapitalization. Calculate earnings per share (EPS) under each of the three economic scenarios assuming the company goes through with recapitalization EBIT Percentage Expected EBIT Less Interest ($95,000 x 8%) EBT = EBIT - Interest Tax 35% Net Income = EBT -tax Shares outstanding EPS Recession $36,000 15.00% $41,400 -$7,600 $33,800 -$11,830 $21,970 2200 $9.99 Normal $36,000 0.00% $36,000 -$7,600 $28,400 -$9,940 $18,460 2200 $8.39 Expansion $36,000 -25.00% $27,000 -$7,600 $19,400 -$6,790 $12,610 2200 $5.73 Market price per share = $150,000/6000 shares $25 per share If $95,000 worth of debt is raised to retire stock, then buying back will be $95,000/$25 = 3,800 shares. So, after recapitalization there will be 6,000 - 3,800 = 2,200 shares outstanding. b-2 Given the recapitalization, calculate the percentage changes in EPS when the economy expands or enters a recession Recession= ($8.39 -$9.99)/8.39 -19.01% Expansion = ($8.39 - $5.73)/$8.39 31.69%

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