RAK, Inc., has no debt outstanding and a total market value of $200,000. Earning
ID: 2763997 • Letter: R
Question
RAK, Inc., has no debt outstanding and a total market value of $200,000. Earnings before interest and taxes, EBIT, are projected to be $24,000 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 30 percent lower. RAK is considering a $70,000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 8,000 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 $200,000. Earnings before interest and taxes, EBIT, are projected to be $24,000 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 30 percent lower. RAK is considering a $70,000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 8,000 shares outstanding. Ignore taxes for this problem.
Explanation / Answer
Part a-1)
The earnings per share under each scenario is calculated as follows:
Normal = EBIT/Number of Shares Outstanding = 24,000/8,000 = $3 per share
Expansion = EBIT*(1+15%)/Number of Shares Outstanding = 24,000*(1+15%)/8,000 = $3.45
Recession = EBIT*(1-30%)/Number of Shares Outstanding = 24,000*(1-30%)/8,000 = $2.10
________
Part a-2)
The percentage change in EPS is calculated as follows:
Recession = (EPS under Recession - EPS under Normal)/EPS under Normal*100 = (2.10 - 3)/3*100 = -30%
Expansion = (EPS under Expansion - EPS under Normal)/EPS under Normal*100 = (3.45 - 3)/3*100 = 15%
________
Part b-1)
The value of each stock is $25 (200,000/8,000). If the company goes with recapitalization, it will have to buy back 2,800 shares (70,000/25). Therefore, after recapitalization, the company will have 5,200 shares (8,000 - 2,800) outstanding.
The revised EPS under each scenario is calculated with the use of following table:
________
Part b-2)
The percentage change in EPS is calculated as follows:
Recession = (EPS under Recession - EPS under Normal)/EPS under Normal*100 = (2.29 - 3.67)/3.67*100 = -37.60%
Expansion = (EPS under Expansion - EPS under Normal)/EPS under Normal*100 = (4.37 - 3.67)/3.67*100 = 19.07%
Recession Normal Expansion EBIT 16,800 24,000 27,600 Less Interest (70,000*7%) 4,900 4,900 4,900 EBT (A) (EBT is same as Net Income without Taxes) 11,900 19,100 22,700 Common Shares Outstanding (B) 5,200 5,200 5,200 EPS (A/B) $2.29 $3.67 $4.37Related Questions
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