Question

Castle, Inc., has no debt outstanding and a total market value of $250,000. Earnings before interest and taxes, EBIT, are projected to be $40,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 20 percent higher. If there is a recession, then EBIT will be 20 percent lower. The firm is considering a debt issue of $105,000 with an interest rate of 4 percent. The proceeds will be used to repurchase shares of stock. There are currently 10,000 shares outstanding. The firm has a tax rate 35 percent. Assume the stock price remains 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. 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. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
  

Percentage changes in EPS
Recession	%
Expansion	%

Answer 1

a-1.EPS is calculated as follows:

	Recession	Normal	Expansion
EBIT	32,000	40,000	48,000
Less: Interest @4%	0	0	0
EBT	32,000	40,000	48,000
Less: Tax@35%	11,200	14,000	16,800
EFE	20,800	26,000	31,200
Number of Shares	10,000	10,000	10,000
EPS	2.08	2.6	3.12

% change in EPS:

Recession: (2.08-2.6)/2.6 = -20%

Expansion: (3.12-2.6)/2.6 = 20%

Stock Price = 250,000/10,000 = $25 per share

b-1: EPS is calculated as follows:

	Recession	Normal	Expansion
EBIT	32,000	40,000	48,000
Less: Interest @4% on 105,000	4,200	4,200	4,200
EBT	27,800	35,800	43,800
Less: Tax@35%	9,730	12,530	15,330
EFE	18,070	23,270	28,470
Number of Shares	5,800	5,800	5,800
EPS	3.12	4.01	4.91

Shares repurchased = 105,000/25 = 4,200

Shares outstanding = 10,000 – 4200 = 5,800

b-2

% change:

Recession: (3.12 – 4.01)/4.01 = -22.19%

Expansion: (4.91-4.01)/4.01 = 22.44%