EBIT and Leverage: RAK, Inc., has no debt outstanding and a total market value o
ID: 2806393 • Letter: E
Question
EBIT and Leverage:
RAK, Inc., has no debt outstanding and a total market value of $165,000. Earnings before interest and taxes, EBIT, are projected to b $21,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 25 percent higher. If there is a recession, then EBIT will be 35 percent lower. The company 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 5,500 shares outstanding. Ignore taxes for this problem.
Calculate earnings per share (EPS) under each of the three economic scenarios before any debt is issued. Also calculate the percentage changes in EPS when the economy expands or enters a recession.
Repeat part (a) assuming that the company goes through with recapitalization. What do you observe?
Explanation / Answer
Without debt, EPS = EBIT / No. of shares
Current Share Price = 165,000 / 5,500 = $30
With 60,000 in debt, no. of shares repurchased = 60,000 / 30 = 2,000
New outstanding shares = 5,500 - 2,000 = 3,500
With debt, EPS = (EBIT - Interest) / No. of shares
where interest = 60,000 x 7% = 4,200
With debt, the change in EPS is higher than without debt.
RAK Expansion Normal Recession EBIT 26,250 21,000 13,650 EPS 4.77 3.82 2.48 % Change 25.00% -35.00% With Debt Expansion Normal Recession EBIT 26,250 21,000 13,650 Interest -4,200 -4,200 -4,200 Profits 22,050 16,800 9,450 EPS 6.30 4.80 2.70 % Change 31.25% -43.75%Related Questions
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