Question

Sunrise, Inc., has no debt outstanding and a total market value of $150,000. 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 20 percent higher. If there is a recession, then EBIT will be 25 percent lower. The company is considering a $60,000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 10,000 shares outstanding. Ignore taxes for this problem. Assume the stock price is constant under all scenarios. 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 Recession percentage change in EPS Expansion percentage change in EPS b-1. Recession EPS Normal EPS b-2. Expansion EPS Recession percentage change in EPS Expansion percentage change in EPS

Answer 1

a-1

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

Recession

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

EPS=28000*(1-0.25)*(1-0)/10000

EPS=2.1

Normal

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

EPS=28000*(1-0)/10000

EPS=2.8

Expansion

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

EPS=28000*(1+0.2)*(1-0)/10000

EPS=3.36

a-2

%age change in EPS for Recession

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

=(2.1/2.8-1)*100

=-25%

%age change in EPS for Growth

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

=(3.36/2.8-1)*100

=20%

b-1

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

=10000-60000/(150000/10000)

=6000

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=(28000*(1-0.25)-60000*0.07)*(1-0)/6000

EPS=2.8

Normal

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

EPS=(28000-60000*0.07)*(1-0)/6000

EPS=3.97

Expansion

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

EPS=(28000*(1+0.2)-60000*0.07)*(1-0)/6000

EPS=4.9

b-2

%age change in EPS for Recession

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

=(2.8/3.9667-1)*100

=-29%

%age change in EPS for Growth

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

=(4.9/3.9667-1)*100

=24%