Question

Castle, Inc., has no debt outstanding and a total market value of $220,000. Earnings before interest and taxes, EBIT, are projected to be $26,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 15 percent higher. If there is a recession, then EBIT will be 20 percent lower. The firm is considering a debt issue of $120,000 with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 11,000 shares outstanding. The firm has a tax rate 35 percent. Assume the stock price remains constant.

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.)

Recession $

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-1). EPS = Net Income / No. of shares Outstanding, (i.e, 11,000)

	Recession	Normal	Expansion
EBIT	$26,000(1 - 0.20) = $20,800	$26,000	$26,000(1 + 0.15) = $29,900
Interest	$0	$0	$0
NI	$20,800	$26,000	$29,900
EPS	$20,800 / 11,000 = $1.89	$26,000 / 11,000 = $2.36	$29,900 / 11,000 = $2.72

b-1). Share price = Equity / Shares outstanding = $220,000 / 11,000 = $20

Shares repurchased = Debt issued / Share price = $120,000 / $20 = 6,000

The interest payment each year under all three scenarios will be:

Interest payment = Debt Issued x Interest Rate = $120,000(0.08) = $9,600

	Recession	Normal	Expansion
EBIT	$26,000(1 - 0.20) = $20,800	$26,000	$26,000(1 + 0.15) = $29,900
Interest	$ 9,600	$ 9,600	$ 9,600
NI	$11,200	$16,400	$20,300
EPS	$11,200 / 5,000 = $2.24	$16,400 / 5,000 = $3.28	$20,300 / 5,000 = $4.06