Music City, Inc., has no debt outstanding and a total market value of $250,000. Earnings before interest and taxes, EBIT, are projected to be $40,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 20 percent higher. If there is a recession, then EBIT will be 20 percent lower. The company is considering a $105,000 debt issue with an interest rate of 4 percent. The proceeds will be used to repurchase shares of stock. There are currently 10,000 shares outstanding. The company has a tax rate 35 percent. Assume the stock price is constant.

Required:
a. Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is issued.
b. Calculate the percentage changes in EPS when the economy expands or enters a recession.
c. Calculate earnings per share (EPS) under each of the three economic scenarios assuming the company goes through with recapitalization.
d. Given the recapitalization, calculate the percentage changes in EPS when the economy expands or enters a recession.

a-1) Calculation of EPS before any debt issue

Recession

Normal

Expansion

EBIT

$32,000

$40,000

$48,000

Since there is no debt and no tax EBIT is the Earnings attributable to the Shareholders

$32,000

$40,000

$48,000

No. of Shares outstanding

10000

10000

10000

EPS (Earnings attributable to Shareholders / No of Shares Outstanding)

$3.20

$4.00

$4.80

EPS

Recession

$ 3.20

Normal

$ 4.00

Expansion

$ 4.80

a-2) Calculation of Percentage changes in EPS when the economy expends or enters a recession:

Recession

Normal

Expansion

EPS (as calculated above in part a-1)

$3.20

$4.00

$4.80

Change in EPS from Normal Scenario

-$0.80

$0

$0.80

Percentage Change

(Change in EPS from Normal Scenario / EPS under Normal Scenario)

-20%

0

20%

Percentage Change in EPS

Recession

-20%

Expansion

20%

b-1) Calculation of EPS with recapitalization

Here recapitalization means considering the issuance of debt for repurchase of stock.

We need to know some figures/amount before calculating the EPS.

No of Shares Outstanding before recapitalization = 10,000

Total Market Value = $250,000

Market Value Per Share = $250,000 / 10,000 = $25

Debt Issue = $105,000

Company will repurchase its share at the market value of shares. Hence No. of Shares to be repurchased = $105,000 / $25 = 4,200

No of Shares Outstanding after recapitalization = 10,000 – repurchased share 4,200 = 5,800

Calculation of EPS with recapitalization

Recession

Normal

Expansion

EBIT

$32,000

$40,000

$48,000

Less: Interest on Debt (105,000*4%)

-$4,200

-$4,200

-$4,200

Earnings attributable to shareholders

(since there is no tax, the earnings after interest part is relates to shareholders)

$27,800

$35,800

$43,800

No of Shares Outstanding after recapitalization

5,800

5,800

5,800

EPS (Earrings attributable to Shareholders / No of Shares Outstanding)

$4.79

$6.17

$7.55

EPS

Recession

$ 4.79

Normal

$ 6.17

Expansion

$ 7.55

b-2) Calculation of Percentage changes in EPS

Recession

Normal

Expansion

EPS (as calculated above in part a-1)

$4.79

$6.17

$7.55

Change from Normal Scenario

-$1.38

($4.79 - $6.17)

$0

$1.38

($7.55 - $6.17)

Percentage Change in EPS (Change in EPS from Normal Scenario / EPS under Normal Scenario)

-22.35%

0

22.35%

Percentage Change in EPS

Recession

-22.35%

Expansion

22.35%

Explanation:

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