RAK Inc has no debt outstanding and a total market value of

RAK, Inc., has no debt outstanding and a total market value of $240,000. Earnings before interest and taxes, EBIT, are projected to be $28,000 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 25 percent lower. RAK is considering a $140,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 12,000 shares outstanding. RAK has a tax rate of 35 percent.

  

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.)

  

  

Calculate the percentage changes in EPS when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

  

  

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.)

  

  

Given the recapitalization, calculate the percentage changes in EPS when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

  

RAK, Inc., has no debt outstanding and a total market value of $240,000. Earnings before interest and taxes, EBIT, are projected to be $28,000 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 25 percent lower. RAK is considering a $140,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 12,000 shares outstanding. RAK has a tax rate of 35 percent.

Solution

Given Data about RAK Inc.:

Total Market Value = $ 240000

EBIT in normal economy scenario = $ 28000

EBIT in strong expansion is 12% higher = $ 28000 (1.12)

= $ 31360

EBIT in recession scenario is 25% lower = $ 28000 (.75)

= $ 21000

Since there is no debt outstanding, therefore there will be no interest expense

Hence EBIT( 1-Tax Rate) = Net Operating after Tax( NOPAT) = Net income

EBIT(1- Tax Rate)= $ 28000(1-0.35)= $ 28000(0.65)= $ 18200

a 1)

In normal case scenario

EPS= Net income/ number of shares otstansding

EPS= $ 18200 / 12000 = 1.52

In strong expansion scenario

Net Income= $ 31360( 1- 0.35) = $ 20384

EPS = $ 20384 / 12000 = 1.70

In recession case scenario

Net Income = $ 21000(1-0.35)= $ 13650

EPS = 13650/12000 = 1.14

a-2)

% change in EPS during recession= [( $1.14- $1.52) / $1.52] * 100

= -25%

% change in EPS during strong economy= [ ( $ 1.70 - $ 1.52) / 1.52] * 100

= 11.84 %

b-1)

Price of the share= Market Value/ Number of shares oustanding

= $ 240000 / 12000

= $ 20

Shares that can be bought back by debt of $ 140000 is = $ 140000 / $ 20

= 7000

Therefore EPS after recapitalization in normal case scenario= (Total earnings - after tax cost of funds) / (shares outstanding after buyback)

= ( $ 28000 - 7000 shares * $ 20 * 0.06) / (12000-7000)

= $ 19600 / 5000

= $ 3.92

In expansion case scenario EPS after recapitalization = ( $ 31360 - 7000 shares * $ 20 * 0.06) / (12000-7000)

= $ 22960 / 5000

= $4.59

In recession case scenario EPS after recapitalization = ( $ 21000 - 7000 shares * $ 20 * 0.06) / (12000-7000)

= $ 12600 / 5000

= $ 2.52

  

b-2)

% Change in EPS during Recession = [($ 2.52 - $ 3.92) / $ 3.92] * 100

= -35.71 %

% Change in EPS during Expansion = [($ 4.59 - $ 3.92) / $ 3.92] * 100

= 17.09 %

  

	EPS
Recession	1.14 $
Normal	1,52 $
Expansion	1.70 $