Question

Castle, 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 firm is considering a debt issue of $100,000 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.)

Recesion $

Normal $

Expansion $

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.)

Recession $

Normal $

Expansion $

Answer 1

a-1Calculation of EPS:

	Recession	Normal	Expansion
EBIT	29,400	42,000	49,560
Less: Interest	0	0	0
Earnings for Equity	29,400	42,000	49,560
Number of Shares	10,000	10,000	10,000
Earnings per Share	2.94	4.2	4.956

b-1Debt issue = $100,000

Value per share = Market value/Number of shares

= 250,000/10,000 = $25

Number of share repurchased = 100,000/25 = 4,000 shares

Calculation of EPS:

	Recession	Normal	Expansion
EBIT	29,400	42,000	49,560
Less: Interest 100,000*8%	8,000	8,000	8,000
Earnings for Equity	21,400	34,000	41,560
Number of Shares	6,000	6,000	6,000
Earnings per Share	$3.57	$5.67	$6.93