Question

Ghost, Inc., has no debt outstanding and a total market value of $140,000. Earnings before interest and taxes, EBIT, are projected to be $32,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 12 percent higher. If there is a recession, then EBIT will be 30 percent lower. The company is considering a $115,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 7,000 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

Ghost, Inc.

a-1) Calculation of Earnings Per Share (EPS) under three economic scenarios:

Economic EPS =

Scenario (Net Income / Common Stock Shares)

i) Normal $4.57 ($32,000/7,000)

ii) Expansion $5.12 ($35,840/7,000)

iii) Recession $3.20 ($22,400/7,000)

a-2) Calculation of the Percentage Changes in EPS, given expansion or recession:

i) Expansion = 12.04% ($5.12 - $4.57)/$4.57 * 100

ii) Recession = -29.98% ($3.20 - $4.57)/$4.57 * 100

b-1) Calculation of Earnings Per Share (EPS) under three economic scenarios after recapitalization:

Interest on debt = $115,000 * 6% = $6,900

Net Income = EBIT - $6,900

Outstanding Common Stock Shares = 1,250 (7,000 - $115,000/20) shares

Economic EPS =

Scenario (Net Income / Common Stock Shares)

i) Normal $20.08 ($25,100/1,250)

ii) Expansion $23.15 ($28,940/1,250)

iii) Recession $12.40 ($15,500/1,250)

b-2) Calculation of the Percentage Changes in EPS, given expansion or recession, after recapitalization:

i) Expansion = 15.29% ($23.15 - $20.08)/$20.08 * 100

ii) Recession = -38.25% ($12.40 - $20.08)/$20.08 * 100

Step-by-step explanation:

a) EPS is Earnings Per Share. It is a financial indicator of the percentage of net income that accrues to common stockholders after the payment of interests and taxes. EPS can be calculated by taking a company's quarterly or annual net income and dividing by the number of its shares of stock outstanding.

b) Expansion: The net income increased to $35,840 ($32,000 x 1.12). After capitalization, this net income will be $28,940 ($35,840 - 6,900).

c) Recession: The net income decreased to $22,400 ($32,000 x 0.7). After capitalization, the net income will become $15,500 ($22,400 - 6,900).

d) Since the total market value is $140,000 with 7,000 shares outstanding, it means that the market price per share is $20 ($140,000/7,000).

e) The outstanding shares will be reduced by 5,750 ($115,000/$20) shares after the debt issue and recapitalization.