Question

Control, Inc. has no debt outstanding and a total market value of $100,000. Earnings before interest and taxes, EBIT, are projected to be $6,000 for the coming year if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 25 percent higher than the original projection. If there is a recession, then EBIT will be 30 percent lower than the original projection. Control is considering a $40,000 debt issue with a 5 percent annual interest rate. The proceeds will be used to repurchase shares of stock. There are currently 2,500 shares. The tax rate is 25 percent. Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is issued. Repeat part A), assuming that Control proceeds with the recapitalization and issues the debt at the beginning of the year. What conclusions do you draw from your analysis?

Answer 1

Earnings per share (EPS) is calculated for Control, Inc. before and after debt issue under various economic scenarios. The net income is determined by adjusting EBIT for taxes and interest from the new debt and then divided by the share count to find EPS, showcasing the impact of financial leverage.

Step-by-step explanation:

The student's question pertains to the calculation of earnings per share (EPS) under three economic scenarios for Control, Inc., both before and after the consideration of a debt issue for stock repurchase. To determine the EPS with no debt, we'll use the provided EBIT projections, adjusted for each scenario, and the current tax rate to find the net income.

Dividing the net income by the number of shares gives us the EPS. For example, under normal conditions, the EBIT is $6,000. After taxes (25%), the net income would be $4,500. Dividing this by the current 2,500 shares, the EPS would be $1.80.

If the company proceeds with the recapitalization, we must account for the interest expense of the new debt ($40,000 at 5%) when calculating the net income. The EPS is recalculated dividing the revised net income by the new, reduced number of shares after repurchase.

We'd expect the EPS to vary under the different economic conditions, possibly being higher when leveraging with debt during favorable economic conditions, and lower if the economy experiences a recession. This analysis helps us understand the financial leverage risks and benefits.