Question

Problem 16-1 EBIT and Leverage [LO1] Ghost, Inc., has no debt outstanding and a total market value of $250,000. Earnings before interest and taxes, EBIT, are projected to be $42,000 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 30 percent lower. The company is considering a $100,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 10,000 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. (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.)

Answer 1

a-1

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

Recession

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

EPS=42000*(1-0.3)*(1-0)/10000

EPS=2.94

Normal

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

EPS=42000*(1-0)/10000

EPS=4.2

Expansion

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

EPS=42000*(1+0.18)*(1-0)/10000

EPS=4.96

a-2

%age change in EPS for Recession

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

=(2.94/4.2-1)*100

=-30%

%age change in EPS for Growth

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

=(4.956/4.2-1)*100

=18%

b-1

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

=10000-100000/(250000/10000)

=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=(42000*(1-0.3)-100000*0.08)*(1-0)/6000

EPS=3.57

Normal

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

EPS=(42000-100000*0.08)*(1-0)/6000

EPS=5.67

Expansion

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

EPS=(42000*(1+0.18)-100000*0.08)*(1-0)/6000

EPS=6.93

b-2

%age change in EPS for Recession

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

=(3.5667/5.6667-1)*100

=-37%

%age change in EPS for Growth

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

=(6.9267/5.6667-1)*100

=22%