I am looking at a company that has no debt outstanding and a total market value of

$1,250,000. Earnings before interest and taxes, EBIT are projected to be $300,000 if
economic conditions are normal. If there is strong expansion in the economy, then EBIT
will be 25% higher. If there is a recession, then EBIT will be 60% lower. The company is
considering a $100,000 debt issue with an 8% interest rate. The proceeds will be used to
repurchase shares of stock. There are currently 10,000 shares outstanding. Ignore taxes
for this problem.
Calculate earrings 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.
(a)
(b)
(c)
(d)
(e)

EPS with recession $_____________

EPS with normal economy $_______________
EPS with expansion $____________________
Percentage change in EPS with recession ___________%
Percentage change in EPS with expansion __________%

EBIT
Interest
Net Income
EPS
% Change in EPS

Recession Normal Expansion

$120,000 $300,000 $375,000
0
0
0
$120,000 $300,000 $375,000
$12.00
$30
$37.50
-60.00%
25.00%

Repeat (a), (b), (c), (d), and (e) assuming the company goes through with recapitalization
(f)
(g)
(h)
(i)
(j)

EPS with recession $_______________

EPS with normal economy $____________
EPS with expansion $_________________
Percentage change in EPS with recession _____________%
Percentage change in EPS with expansion ____________%

EBIT
Interest
Net Income
EPS
% Change in EPS

3)

Recession Normal Expansion

$120,000 $300,000 $375,000
$8,000
$8,000
$8,000
$112,000 $292,000 $367,000
$12.17
$32
$39.89
-61.64%
25.68%

ROE and LEVERAGE

Suppose the company in the previous problem has a market-to-book ratio of 1.0.
Calculate return on Equity, ROE, under each of the three economic scenarios before any
debt is issued. Also, calculate the percentage changes in ROE for economic expansion
and recession assuming no taxes. (Hint: with no taxes or interest, ROE=EBIT/Equity)
Since the company has a market-to-book ratio of 1.0, the total
equity of the firm is equal to the market value of equity. Using
the equation for ROE:
ROE = NI / Total Equity

ROE
% Change in ROE

Recession
0.096
-60.00%

Normal
0.24
-

Expansion
0.3
25.00%

(a) ROE with recession ____________%

(b) ROE with normal economy ____________%
(c) ROE with expansion _____________%
Calculate the ROE in each of the three economic scenarios assuming the firm goes
through with the proposed recapitalization. (Hint: ROE=[EBIT-interest Expense]/Equity)
If the company undertakes the proposed recapitalization, the
new equity value will be:
Equity = $1,250,000 (800 $125)
Equity = $1,150,000

ROE
% Change in ROE

Recession Normal Expansion

0.0973913 0.253913 0.3191304
-61.64%
25.68%

(d) ROE with recession__________%

(e) ROE with normal economy _____________%
(f) ROE with expansion _________________%

Calculate ROE in each of the three economic scenarios before any debt is issued
assuming the firm has a tax rate of 35%. (Hint: ROE =[EBIT-Interest Expense]/Equity)

EBIT
Interest
Taxes @ 35%
Net Income
ROE
% Change in ROE

Recession
$120,000
0
$42,000
$78,000
0.0624
-60.00%

Normal
$300,000
0
$105,000
$195,000
0.156
-

Expansion
$375,000
0
$131,250
$243,750
0.195
25.00%

(g) ROE with recession _____________%

(h) ROE with normal economy _______________%
(i) ROE with expansion _______________%
Calculate ROE in each if the three economic scenarios assuming the firm goes through
with the proposed recapitalization and has a tax rate of 35%. (Hint: ROE = [EBIT-Interest
Expense-Tax]/Equity.

EBIT
Interest
EBT
Taxes @ 35%
Net Income
ROE
% Change in ROE

Recession
$120,000
$8,000
$112,000
$39,200
$72,800
0.06330
-61.64%

(j) ROE with recession ____________%

(k) ROE with normal economy ___________%
(l) ROE with expansion ________________%

Normal
$300,000
$8,000
$292,000
$102,200
$189,800
0.16504
-

Expansion
$375,000
$8,000
$367,000
$128,450
$238,550
0.20743
25.68%