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2 September, 12:43

Ghost, Inc., has no debt outstanding and a total market value of $369,600. Earnings before interest and taxes, EBIT, are projected to be $51,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 15 percent higher. If there is a recession, then EBIT will be 24 percent lower. The company is considering a $185,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 8,400 shares outstanding. The company has a tax rate of 24 percent, a market-to-book ratio of 1.0, and the stock price remains constant. a-1. 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.) a-2. Calculate the percentage changes in EPS when the economy expands or enters a recession.

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  1. 2 September, 15:51
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    Ghost Inc.

    A1.

    Earnings Per share (EPS)

    EPS in normal projection is $4.61 per share

    EPS in an expansion is $5.31 Per share

    EPS in a recession is $3.51 Per share

    A2.

    Changes to EPS in an expansion is + 15.18%

    Changes to EPS in a recession is - 23.86%

    B1.

    Earnings Per share (EPS)

    EPS in normal projection is $7.23 per share

    EPS in an expansion is $8.62 Per share

    EPS in a recession is $5.01 Per share

    B2.

    Changes to EPS in an expansion is + 19.23%

    Changes to EPS in a recession is - 30.71%

    Step-by-step explanation:

    Underlying Information:

    Earnings before interest and taxes, EBIT projections = $51,000

    Expansionary EBIT projections = $51,000 x (100% + 15%) = $58,650

    Recessionary EBIT projections = $51,000 x (100% - 24%) = $38,760

    Tax Rate = 24%

    Market to Book Ratio = 1.0

    Stock Price is constant.

    Solution to A1.

    Scenario 1 (Projected Earnings)

    Earnings Per Share (EPS) = Net Income (Earnings after Tax) divided by Outstanding Shares in Issue

    Net Income = EBIT minus tax = $51,000 - ($51,000 x 24%)

    = $51,000 - $12240

    = $38,760

    Outstanding shares in issue = 8,400 ordinary Shares

    EPS = $38,760 divided by 8,400 shares = $4.61 Per share

    Scenario 2 (Projected Earnings in a strong expansion)

    Earnings Per Share (EPS) = Net Income (Earnings after Tax) divided by Outstanding Shares in Issue

    Net Income = EBIT minus tax = $58,650 - ($58,650 x 24%)

    = $58,650 - $14,076

    = $44,574

    Outstanding shares in issue = 8,400 ordinary Shares

    EPS = $44,574 divided by 8,400 shares = $5.31 Per share

    Scenario 3 (Projected Earnings in a Recession)

    Earnings Per Share (EPS) = Net Income (Earnings after Tax) divided by Outstanding Shares in Issue

    Net Income = EBIT minus tax = $38,760 - ($38,760 x 24%)

    = $38,760 - $9,302.4

    = $29,457.6

    Outstanding shares in issue = 8,400 ordinary Shares

    EPS = $44,574 divided by 8,400 shares = $3.51 Per share

    Solution to A2.

    1. Changes to EPS in an expansion = EPS (Expansion) minus EPS (normal projection), all divided by EPS (normal projection)

    = (5.31 - 4.61) / 4.61

    = + 15.18% change during an expansion

    2. Changes to EPS in a recession = EPS (Recession) minus EPS (normal projection), all divided by EPS (normal projection)

    = (3.51 - 4.61) / 4.61

    = - 23.86% change during a recession

    Underlying Information:

    Debt issue = $185,000

    Interest on debt issued = 6% = $11,100

    Market to Book Ratio = 1.0

    Stock Price is constant.

    Therefore Share Price = Market Value divided by Outstanding shares in issue = 369,600 / 8400 = $44

    This implies our proceeds of $185,000 from debt issue would have repurchased $185,000 divided by $44 = 4,205 ordinary shares

    This decision to repurchase its shares indicates the shares outstanding will reduce by 4,205. New outstanding shares will now be 4,195 shares

    *Earnings before interest and taxes, EBIT normal projections = $51,000 & Earnings Before Tax (EBT) = $51,000 minus $11,100 (debt interest) = $39,900

    *Expansionary EBIT projections = $51,000 x (100% + 15%) = $58,650 & Earnings Before Tax = $58,650 minus $11,100 (debt interest) = $47,550

    *Recessionary EBIT projections = $51,000 x (100% - 24%) = $38,760 & Earnings Before Tax = $38,760 minus $11,100 (debt interest) = $27,660

    Tax Rate = 24%

    Solution to B1.

    Scenario 1 (Projected Earnings)

    Earnings Per Share (EPS) = Net Income (Earnings after Tax) divided by Outstanding Shares in Issue

    Net Income = EBT minus tax = $39,900 - ($39,900 x 24%)

    = $39,900 - $9,576

    = $30,324

    Outstanding shares in issue = 4,195 ordinary Shares

    EPS = $30,324 divided by 4,195 shares = $7.23 Per share

    Scenario 2 (Projected Earnings in a strong expansion)

    Earnings Per Share (EPS) = Net Income (Earnings after Tax) divided by Outstanding Shares in Issue

    Net Income = EBT minus tax = $47,550 - ($47,550 x 24%)

    = $47,550 - $11,412

    = $36,138

    Outstanding shares in issue = 4,195 ordinary Shares

    EPS = $36,138 divided by 4,195 shares = $8.62 Per share

    Scenario 3 (Projected Earnings in a Recession)

    Earnings Per Share (EPS) = Net Income (Earnings after Tax) divided by Outstanding Shares in Issue

    Net Income = EBT minus tax = $27,660 - ($27,660 x 24%)

    = $27,660 - $6,638.40

    = $21,021.60

    Outstanding shares in issue = 4,195 ordinary Shares

    EPS = $21,021.60 divided by 4,195 shares = $5.01 Per share

    Solution to B2.

    1. Changes to EPS in an expansion = EPS (Expansion) minus EPS (normal projection), all divided by EPS (normal projection)

    = (8.62 - 7.23) / 7.23

    = + 19.23% change during an expansion

    2. Changes to EPS in a recession = EPS (Recession) minus EPS (normal projection), all divided by EPS (normal projection)

    = (5.01 - 7.23) / 7.23

    = - 30.71% change during a recession
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