Donny, Inc., has no debt outstanding and a total market value of $100,000. Earni

Question

Donny, Inc., has no debt outstanding and a total market value of $100,000. Earnings before interest and taxes, EBIT, are projected to be $8,400 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 24 percent higher. If there is a recession, then EBIT will be 31 percent lower. Donny is considering a $35,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 4,000 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. Round your answers to 2 decimal places

Calculate the percentage changes in EPS when the economy expands or enters a recession. (Do not round intermediate calculations. Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places

Calculate earnings per share, EPS, under each of the three economic scenarios after the recapitalization. (Do not round intermediate calculations. Round your answers to 2 decimal places

Calculate the percentage changes in EPS when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places

Donny, Inc., has no debt outstanding and a total market value of $100,000. Earnings before interest and taxes, EBIT, are projected to be $8,400 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 24 percent higher. If there is a recession, then EBIT will be 31 percent lower. Donny is considering a $35,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 4,000 shares outstanding. Ignore taxes for this problem.

Explanation / Answer

Market value of company = $100,000

Number of outstanding share = 4,000

Price per share = $100,000 / 4,000

                         = $25

Price per share of company is $25.

Current EBIT = $8,400

EBIT in case of Expansion = $8,400 × (1+24%)

                                            = $10,416

EBIT in case of recession = $32,000 × (1 - 31%)

                                            = $5,796

Company planning to raise 35,000 as debt to repurchase stock. Interest rate on debt is 6%.

Total interest on debt = $35,000 × 6%

                                   = $2,100

Total number of share repurchase from $5,000 at current price of $25 per share is calculated below:

Number of share repurchase = $35,000 / $25

                                              = $1,400

After repurchase number of share remains = 4,000 – 1,400

                                                                    = 2,600

Now earnings per share in normal case is calculated below:

EPS = ($8,400 - $2,100) / 2,600

        = $2.43

Earning in case of normal economy is $2.43.

Earnings per share in expansion case is calculated below:

EPS = ($10,416 - $2,100) / 2,600

        = $3.20

Earning in case of expansion economy is $3.20.

Earnings per share in recession case is calculated below:

EPS = ($5,796 - $2,100) / 2,600

        = $1.42

Earning in case of recession economy is $1.42.

b.

Percentage change in EPS from normal economy to expansion economy is calculated below:

= ($3.20 – $2.43) / $2.43

=31.69%

Hence, Percentage change in EPS from normal economy to expansion economy is 31.69%

Percentage change in EPS from normal economy to recession economy is calculated below:

= ($1.42 – $2.43) / $2.43

= -41.53%

Hence, Percentage change in EPS from normal economy to recession economy is -41.56%

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