Chapter 13 Business Finance

Chapter 13: Questions and Problems

1. Kaelea, Inc., has no debt outstanding and a total market value of $90,000. Earnings before interest and taxes, EBIT, are projected to be $8,000 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 35 percent lower. Kaelea is considering a $34,000 debt issue with a 6 percent interest rate. The proceeds will be used to purchase shares of stock. There are currently 3,600 shares outstanding. Ignore taxes for this problem.

a. Calculate earning per share, EPS, under each of the three economic scenarios before any debts is issued. Also, calculate the percentage changes in EPS when the economy expands or enter a recession.

Current Proposed

Assets 90000 90000

Debt 0 34000

Equity 90000 56000

Debt-equity ratio 0 60.7

Share price $25 $25

Shares outstanding 3600 2240 34000/25=1360, 3600-1360=2240

Interest rate 6 6

Current Capital Structure: No Debt

Recession Expected Expansion

EBIT 5200 8000 9600

Interest 0 0 0

Net Income 5200 8000 9600

ROE 5.78% 8.89% 10.67%

EPS $1.44 $2.22 $2.67

ROE = Net income/Total equity

EPS = Net income/Shares outstanding

EPS

Recession = $1.44

Expected = $2.22

Expansion= $2.67

Percentage changes in EPS

Recession = 35% down

Expansion = 20.3% up

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

Proposed Capital Structure: Debt = $34,000

Recession Expected Expansion

EBIT 5200 8000 9600

Interest 2040 2040 2040

Net Income 3160 5960 7560

ROE 5.64% 10.64% 13.50%

EPS $1.41 $2.66 $3.38

EPS

Recession = $1.41

Expected = $2.66

Expansion= $3.38

Percentage changes in EPS

Recession = 47% down

Expansion = 27.1% up

It does seem like a good idea to proceed with the proposal because with both...