Question

# Castle, Inc., has no debt outstanding and a total market value of \$220,000. Earnings before interest...

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 \$

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

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