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 $28,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 10 percent higher. If there is a recession, then EBIT will be 25 percent lower. The company is considering a $48,000 debt issue with an interest rate of 4 percent. The proceeds will be used to repurchase shares of stock. There are currently 20,000 shares outstanding. Ignore taxes for this problem. Assume the stock price is constant.

  

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. (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.)

  

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. (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.)

  

Percentage changes in EPS
Recession	%
Expansion	%

Answer 1

Normal:

EBIT = $28,000

Recession:

EBIT = $28,000 - 25% * $28,000
EBIT = $21,000

Expansion:

EBIT = $28,000 + 10% * $28,000
EBIT = $30,800

Answer a-1.

Total Value = $240,000
Number of shares outstanding = 20,000

Price per share = Total Value / Number of shares outstanding
Price per share = $240,000 / 20,000
Price per share = $12.00

Recession 21000 Normal 28000 Expansion 30800 21000 28000 30800 EBIT Less: Interest EBT Less: Taxes Net Income # of shares EPS 21000 20000 1.05 28000 20000 1.40 30800 20000 1.54

Answer a-2.

If economy expand:

Percentage Change in EPS = ($1.54 - $1.40) / $1.40
Percentage Change in EPS = 10.00%

If economy collapse:

Percentage Change in EPS = ($1.05 - $1.40) / $1.40
Percentage Change in EPS = -25.00%

Answer b-1.

Value of Debt = $48,000

Interest Expense = 4% * $48,000
Interest Expense = $1,920

Value of Equity = $192,000
Price per share = $12.00

Number of shares outstanding = $192,000 / $12.00
Number of shares outstanding = 16,000

Recession 21000 1920 19080 Normal 28000 1920 26080 Expansion 30800 1920 28880 ЕВТ Less: Interest EBT Less: Taxes Net Income # of shares EPS 19080 16000 1.19 26080 16000 1.63 28880 16000 1.81

Answer b-2.

If economy expand:

Percentage Change in EPS = ($1.81 - $1.63) / $1.63
Percentage Change in EPS = 11.04%

If economy collapse:

Percentage Change in EPS = ($1.19 - $1.63) / $1.63
Percentage Change in EPS = -26.99%