Question

Music City, Inc., has no outstanding debt and its total market value is $200,000. Earnings before interest and taxes, EBIT, is projected at $26,000, assuming normal economic conditions. If there is a strong expansion in the economy, then EBIT will be 12 percent higher. If there is a recession, then EBIT will be 25 percent lower. The company is considering a debt issue of $65,000 with an interest rate of 6 percent. The funds raised will be used to buy back shares. There are currently 10,000 shares outstanding. The company has a tax rate of 35 percent. Assume that the stock price is constant.

a-1. Calculate earnings per share (EPS) in each of the three economic scenarios before issuing debt. (Do not round intermediate calculations. Enter your answer to two decimal places, for example, 32.16.)
a-2. Calculate the percentage changes in EPS when the economy expands or enters a recession. (A negative answer should be indicated with a minus sign. Do not round intermediate calculations. Enter your answer as a percentage rounded to the nearest integer, for example, 32.)
b-1. Calculate earnings per share (EPS) in each of the three economic scenarios, assuming that the company undergoes recapitalization. (Do not round intermediate calculations. Enter your answer to two decimal places, for example, 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 with a minus sign. Do not round intermediate calculations. Enter your answer as a percentage rounded to two decimal places, for example, 32.16.)

Answer 1

To calculate the EPS in each economic scenario, we use the projected EBIT and tax rate. In the normal economic condition, the EPS is $1.69 per share. In the expansion scenario, the EPS is $1.89 per share. In the recession scenario, the EPS is $1.27 per share. The percentage change in EPS when the economy expands is 11.83% and when it enters a recession is -24.85%.

Step-by-step explanation:

To calculate the earnings per share (EPS) in each of the three economic scenarios before issuing debt, we need to consider the projected EBIT in each scenario and the tax rate.

1. For normal economic conditions, the EBIT is projected at $26,000. To calculate EPS, we subtract the taxes from EBIT and divide the result by the number of shares. EBIT (1 - Tax rate) / Number of shares = EPS. Substituting the values, we get (26000 * (1 - 0.35)) / 10000 = $1.69 per share.
2. For the strong expansion in the economy, the EBIT will be 12% higher than the normal projected EBIT. So, the EBIT will be $26,000 * (1 + 0.12) = $29,120. Using the same formula as before, EPS = (29120 * (1 - 0.35)) / 10000 = $1.89 per share.
3. For the recession scenario, the EBIT will be 25% lower than the normal projected EBIT. So, the EBIT will be $26,000 * (1 - 0.25) = $19,500. Using the same formula as before, EPS = (19500 * (1 - 0.35)) / 10000 = $1.27 per share.

To calculate the percentage changes in EPS when the economy expands or enters a recession, we use the formula: (New EPS - Old EPS) / Old EPS * 100.

1. When the economy expands, the EPS increases from $1.69 to $1.89. Substituting the values, the percentage change is ($1.89 - $1.69) / $1.69 * 100 = 11.83% (rounded to the nearest integer).
2. When the economy enters a recession, the EPS decreases from $1.69 to $1.27. Substituting the values, the percentage change is ($1.27 - $1.69) / $1.69 * 100 = -24.85% (rounded to the nearest integer).