Question

Sunrise, Inc., has no debt outstanding and a total market value of $332,100. Earnings before interest and taxes, EBIT, are projected to be $48,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 18 percent higher. If there is a recession, then EBIT will be 29 percent lower. The company is considering a $170,000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 8,100 shares outstanding. The company has a tax rate of 21 percent, a market-to-book ratio of 1.0, and 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.)
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 2 decimal places, e.g., 32.16.)
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.)
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.)

	a-1. Recession EPS Normal EPS Expansion EPS a-2. Recession percentage change in EPS -29.00 % Expansion percentage change in EPS 18.00 % b-1. Recession EPS Normal EPS b-2. Expansion EPS Recession percentage change in EPS -38.56 % Expansion percentage change in EPS 23.93 %

Answer 1

a-1

EPS = EBIT*(1-tax rate)/shares outstanding

Recession

EPS = EBIT*(1-recession impact%)*(1-tax rate)/shares outstanding

EPS=48000*(1-0.29)*(1-0.21)/8100

EPS=3.32

Normal

EPS = EBIT*(1-tax rate)/shares outstanding

EPS=48000*(1-0.21)/8100

EPS=4.68

Expansion

EPS = EBIT*(1+Growth impact%)*(1-tax rate)/shares outstanding

EPS=48000*(1+0.18)*(1-0.21)/8100

EPS=5.52

a-2

%age change in EPS for Recession

=(EPS recession/EPS normal-1)*100

=(3.3239/4.6815-1)*100

=-29%

%age change in EPS for Growth

=(EPS Growth/EPS normal-1)*100

=(5.5241/4.6815-1)*100

=18%

b-1

New no. of shares = old shares-debt/(Market value/old shares)

=8100-170000/(332100/8100)

=3954

EPS = (EBIT-debt*interest%)*(1-tax rate)/new shares outstanding

Recession

EPS = (EBIT*(1-recession impact%)-debt*interest %age)*(1-tax rate)/new shares outstanding

EPS=(48000*(1-0.29)-170000*0.07)*(1-0.21)/3954

EPS=4.43

Normal

EPS = (EBIT-debt*interest%)*(1-tax rate)/new shares outstanding

EPS=(48000-170000*0.07)*(1-0.21)/3954

EPS=7.21

Expansion

EPS = (EBIT*(1+growth impact%)-debt*interest %age)*(1-tax rate)/new shares outstanding

EPS=(48000*(1+0.18)-170000*0.07)*(1-0.21)/3954

EPS=8.94

b-2

%age change in EPS for Recession

=(EPS recession/EPS normal-1)*100

=(4.4315/7.2127-1)*100

=-39%

%age change in EPS for Growth

=(EPS Growth/EPS normal-1)*100

=(8.9389/7.2127-1)*100

=24%