Question

1. Pendergast, Inc., has no debt outstanding, and has a total market value of $180,000. Earnings before interest and taxes (EBIT) are projected to be $23,000 if economic conditions are normal. If there is a strong expansion in the economy, then EBIT will be 20% higher. If there is a recession, then EBIT will be 30% lower. Pendergast is considering a $75,000 debt issue with a 7% interest rate. The proceeds will be used to repurchase shares of stock. There are currently 6,000 shares of stock outstanding, and the relevant tax rate is 35%. a- Calculate ROE and EPS under each of the economic scenarios before any debt is issued. b- Repeat part a, assuming that the company goes through with the capitalization C- Calculate the percentage changes in EPS when the economy expands or enters a recession.

Answer 1

a.
All equity	Normal	Expansion(Normal*1.2)	Recession(Normal*(1-30%)
EBIT	23000	27600	16100
Less: Tax at 35%	8050	9660	5635
EAT/Net Income	14950	17940	10465
No.of shareso/s	6000	6000	6000
EPS=EAT/No.of shares	14950/6000=	17940/6000=	10465/6000=
	2.49	2.99	1.74
Value of equity	180000	180000	180000
ROE=Net Income/Total equity	14950/180000=	17940/180000=	10465/180000=
	8.31%	9.97%	5.81%

b.
Market value of equity=	180000
No.of shares o/s=	6000
Market price/share=(180000/6000)=	30
So, no of shares that can be repurchased with $ 75000=	75000/30=
	2500
So, under scenario b.
no.of shares o/s will be 6000-2500=	3500
Debt & equity	Normal	Expansion(Normal*1.2)	Recession(Normal*(1-30%)
EBIT	23000	27600	16100
Less:Interest on debt(75000*7%)	5250	5250	5250
EBT	17750	22350	10850
Less: Tax at 35%	6213	7823	3798
EAT/Net Income	11538	14528	7053
No.of shareso/s	3500	3500	3500
EPS=EAT/No.of shares	11538/3500=	14528/3500=	7053/3500=
	3.30	4.15	2.02
Value of equity(180000-75000) OR(3500 shs.*$30)	105000	105000	105000
ROE=Net Income/Total equity	11538/105000=	14528/105000=	7053/105000=
	10.99%	13.84%	6.72%

c.EPS under	Normal	Expansion	Recession
All Equity	2.49	2.99	1.74
Debt & equity	3.30	4.15	2.02
% change		(4.15-2.99)/2.99=	(2.02-1.74)/1.74=
		38.80%	16.09%