Question

Sunrise, Inc., has no debt outstanding and a total market value of $245,000. Earnings before interest and taxes, EBIT, are projected to be $19,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 25 percent higher. If there is a recession, then EBIT will be 40 percent lower. The company is considering a $58,800 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,000 shares outstanding. Ignore taxes for this problem. Assume the stock price is constant under all scenarios.

Required:
a. Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is issued. Also calculate the percentage changes in EPS when the economy expands or enters a recession.
b. Repeat part (a) assuming that the company goes through with recapitalization. What do you observe?

Answer 1

Answer:

Sunrise, Inc.

a. Earnings per share (EPS) under the three economic scenarios before debt is issued:

Scenarios       EBIT      EPS                                  Percentage Changes

Normal       $19,000  $3.80 ($19,000/5,000)

Expansion $23,750  $4.75 ($23,750/5,000)    25% ($0.95/$3.80 * 100)

Recession  $11,400  $2.28 ($11,400/5,000)      40% ($1.52/$3.80 * 100)

b. After capitalization, Earnings per share (EPS) under the three economic scenarios:

Repurchase of stock = $58,800/$49 = 1,200 shares

Outstanding shares = 3,800 (5,000 - 1,200)

Interest expense = $4,700 approx.

Net Income (taxes ignored) = $14,300

Scenarios                   Net income                

Normal                       $14,300 ($19,000 - $4,700 Interest)    

Strong Expansion     $17,875 ($14,300 * 1.25)

Recession                 $8,580 ($14,300 * 0.60)

Scenarios  Net income      EPS                           Percentage Changes

Normal       $14,300     $3.76 ($14,300/3,800)

Expansion  $17,875     $4.70 ($17,875/3,800)    25% ($0.94/$3.76 * 100)

Recession  $8,580     $2.25 ($8,580/3,800)     40% ($1.51/$3.76 * 100)

Observation:

The EPS changed under each scenario when the debt was issued, but the percentage changes remained similar to the changes before the debt issue.   This can be attributed to the change in the outstanding shares from 5,000 to 3,800.  With the debt issue, the EBIT is not used in the calculations but the income after taxes.

Explanation:

a) Data and Calculations:

Total market value = $245,000

Outstanding shares = 5,000

Market price per share = $49 ($245,000/5,000)

EBIT (Earnings before interest and taxes) = $19,000 (normal economic condition)

Scenarios                   EBIT                

Normal                       $19,000    

Strong Expansion     $23,750 ($19,000 * 1.25)

Recession                 $11,400 ($19,000 * 0.60)

Debit issue = $58,800

Interest rate of debt = 8%