Question

Pendergast, Inc., has no debt outstanding and a total market value of $180,000. Eamings before interest and taxes, EBIT, are projected to be $23,000 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 30 percent lower. Pendergast is considering a S75,000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 6.000 shares outstanding. Ignore taxes for this problem. a-1 Calculate earnings per share (EPS) under each of the three economic scenarios before any debt is issued. (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. (Negative amounts should be indicated by a minus sign.) Percentage changes in EPS Recession Expansion % b.1 Assume that the company goes through with recapitalization. Calculate earnings per share (EPS) under each of the three economic scenarios assuming the company goes through with recapitalization. (Leave no celils blank be certain to enter "0" wherever required. 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. (Negative amounts should be indicated by a minus sign. Round your answerss to 2 decimal places. (e.g.. 32.16 Percentage changes in EPS Recession Expansion

Answer 1

Solution:

In this problem you have to calculate return on equity. At present company has no debt. It has issued stock of 6,000 numbers. total market value is $180,000. The market value is also book value of this 6,000 stocks.

Now company has projected EBIT of $23,000 under normal situation. It will increase by 20% in expansion situation and will decrease by 30% on depression. Hence ROE is ascertained from total EBIT available for equity holders divided by total book value of stock. Thus formula is:

$\textup{ROE} =\frac{\textup{Earning available to equity stock}}{\textup{Book value of stock}}\times 100$

On the basis of above formula, calculations are shown in the table below:

Return on equity when no debt is issued
	Recession	Normal	Expansion
1. EBIT
- Normal		$23,000
- Recession [ Normal x 70%]	$16,100
- Expansion [ Normal x120%]			$27,600
2. Market value/ book value	$180,000	$180,000	$180,000
3. ROE in % [ 1/2]*100	8.95	12.78	15.33

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Answer: a-2

On the basis of above ROE now you have to ascertain change in ROE under recssion and expansion situation. It is shown below:

Percentage change in ROE in expansion:

Percentage change in ROE = 15.33 - 12.78 / 12.78 * 100 = 20%

Percentage change in ROE in recession:

Percentage change in ROE = 8.95 - 12.78 / 12.78 * 100 = -30%

Answer-b-1:

Now company has decided to change its compostion of fund. It will issue $ 75,000 debt at 7%. This money will be used to buy back equity. Thus $75,000 will be used to repurchase stock from the market. At present price of a stock in market is:

Stock Price = 180,000/6000 = $30

So It will buy

75,000/30 = 2,500stock

After this purchase number of stock left will be

6,000 - 2,500 = 3,500stock

Now calculate earning available to equity stock holder.

	Recession	Normal	Expansion
1. EBIT	$16,100	$23,000	$27,600
2. Interest [7% of $75,000]	$5,250	$5,250	$5,250
3. Earning for coomon stock [1- 2]	$10,850	$17,750	$22,350
4. Book value of equity [3,500x $30]	$105,000	$105,000	$105,000
5. ROE [(3)*100/(4)]	10.33%	16.90%	21.28%

Answer b-2

Use result of b-1 to ascertain change in ROE

Change in ROE under expansion:

Percentage change in ROE = 21.28 - 16.90 / 16.90 * 100 = 25.91%

Change in ROE under recession

Percentage change in ROE = 10.33 - 16.90 / 16.90 * 100 = -38.87 %