Answer:
See the explanation below:
Explanation:
a- Calculate ROE and EPS under each of the economic scenarios before any debt is issued.
Under an expansion
Earnings before interest and taxes (EBIT) = $23,000 * (100% + 20%) = $27,600
Earnings after taxes = $27,600 * (100% - 35%) = $17,940
Return on equity (ROE) = Earnings after taxes / Total market value of equity = $17,940 / $180,000 =
0.0997, or 9.97%
Earnings per share (EPS) = Earnings after taxes / Number of shares of stock outstanding = $17,940 /
6,000 = $2.99 per share
Under a recession
Earnings before interest and taxes (EBIT) = $23,000 * (100% - 30%) = $16,100
Earnings after taxes = $16,100 * (100% - 35%) = $10,465
Return on equity (ROE) = Earnings after taxes / Total market value of equity = $10,465 / $180,000 =
0.0581, or 5.81%
Earnings per share (EPS) = Earnings after taxes / Number of shares of stock outstanding = $10,465 /
6,000 = $1.74 per share
b- Repeat part a, assuming that the company goes through with the capitalization.
Under an expansion
Earnings before interest and taxes (EBIT) = $23,000 * (100% + 20%) = $27,600
Interest on debt = $75,000 * 7% = $5,250
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Earnings after interest = $27,600 - $5,250 = $22,350
Earnings after taxes = $22,350 * (100% - 35%) = $14,527.50
Return on equity (ROE) = Earnings after taxes / Total market value of equity = $14,527.50/ $180,000 =
0.0807, or 8.07%
Earnings per share (EPS) = Earnings after taxes / Number of shares of stock outstanding = $14,527.50 /
6,000 = $2.42 per share
Under a recession
Earnings before interest and taxes (EBIT) = $23,000 * (100% - 30%) = $16,100
Interest on debt = $75,000 * 7% = $5,250
Earnings after interest = $16,100 - $5,250 = $10,850
Earnings after taxes = $10,850 * (100% - 35%) = $7,052.50
Return on equity (ROE) = Earnings after taxes / Total market value of equity = $7,052.50 / $180,000 =
0.0392, or 3.92%
Earnings per share (EPS) = Earnings after taxes / Number of shares of stock outstanding = $7,052.50 /
6,000 = $1.18 per share
c- Calculate the percentage changes in EPS when the economy expands or enters a recession.
Percentage change under expansion = ($2.42 - $2.99)/$2.99 = 0.1902 decrease, or 19.02% decrease.
Percentage change under recession = ($1.18 - $1.74)/ $1.74 = 0.3218 decrease, or 32.18% decrease
