Kaelea, Inc., has no debt outstanding and a total market value of $125,000. Earnings before interest and taxes, EBIT, are projected to be $10,400 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 35 percent lower. Kaelea is considering a $42,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 6,250 shares outstanding.

Ignore taxes for this problem.

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 Kaelea goes through with recapitalization. What do you observe?

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.

Under normal condition:

EPS under normal condition = $10,400 / 6,250 = $1.664 per share

Under strong expansion:

EPS under strong expansion = ($10,400 * 1.20) / 6,250 = $1.9968 per share

Percentage in EPS under strong expansion = ((1.9968 - 1.664) / 1.664) * 100 = 20% increase

Under a recession:

EPS under a recession = ($10,400 * (1 -35%)) / 6,250 = $ 1.0816 per share

Percentage in EPS under strong expansion = ((1.0816 - 1.6640) / 1.664) * 100 = 35% decrease

b. Repeat part ( a ) assuming that Kaelea goes through with recapitalization. What do you observe?

Interest on debt = $42,000 * 6% = $2,520

Under normal condition:

Earnings after interest = $10,400 - $2,520 = $7,880

EPS under normal condition = $7,880 / 6,250 = $1.2608 per share

Under strong expansion:

Earnings after interest = ($10,400 * 1.2) - $2,520 = $9.960

EPS under strong expansion = $9,960 / 6,250 = $1.5936 per share

Percentage in EPS under strong expansion = ((1.5936 - 1.2608) / 1.2608) * 100 = 26.40% increase

Under a recession:

Earnings after interest = ($10,400 * (1 - 35%)) - $2,520 = $4,240

EPS under a recession = $4,240 / 6,250 = $0.6784 per share

Percentage in EPS under strong expansion = ((0.6784 - 1.2608) / 1.2608) * 100 = 46.19% decrease

Observations:

1. The increase in EPS of 26.40% is greater than the increase of 20% in earning before interest and tax under a strong expansion if the company goes through the recapitalization.

2. The decrease in EPS of 46.19% is greater than the decrease of 30% in earning before interest and tax under a recession if the company goes through the recapitalization.

Therefore, EPS will be more affected under recapitalization than without it.