Music City, Inc., has no debt outstanding and a total market value of $240,000.

Question

Music City, Inc., has no debt outstanding and a total market value of $240,000. Earnings before interest and taxes, EBIT, are projected to be $26,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 18 percent higher. If there is a recession, then EBIT will be 20 percent lower. The company is considering a 5150,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 15,000 shares outstanding. Ignore taxes for this problem. Assume the stock price is constant. 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. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answers as a percent rounded to the nearest whole number, e.g., 32.) 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.) Given the recapitalization, calculate the percentage changes in EPS when the economy expands or enters a recession. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

Explanation / Answer

Answer b 1 Market value of shares = $240000 No.of shares outstanding = 15000 Market price per share = $240000 / 15000 = $16 per share Debt issue to repurchase the stock = $150000 No.of shares purchased using debt proceeds = $150000 / $16 = 9375 shares No.of shares outstanding after repurchase = 15000 - 9375 = 5625 shares Yearly Interest payable on debt = 8% * $150000 = $12000 EBIT Interest on debt Profit before tax Tax Profit after tax No.of shares outstanding EPS A B C= A - B D E = C - A F E / F Recession $20,800 $12,000 $8,800 $0 $8,800 5625 $1.56 Normal $26,000 $12,000 $14,000 $0 $14,000 5625 $2.49 Expansion $30,680 $12,000 $18,680 $0 $18,680 5625 $3.32 Answer b 2 Percentage change in EPS when economy expands = ($3.32 - $2.49) / $2.49 = 33.33% higher Percentage change in EPS when economy enters recession = ($2.49 - $1.56) / $2.49 = 37.35% lower

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