Corporate Finance

Full Answer Section

• Recession: EBIT = $25,000 * (1 - 50%) = $12,500; EPS = $12,500 / 5,000 shares = $2.50/share; Change = 50% decrease

b) After Recapitalization:

• Proceeds from debt issuance: $100,000
• Shares repurchased: $100,000 / $5/share (initial EPS) = 20,000 shares
• New shares outstanding: 5,000 shares - 20,000 shares = 3,000 shares
• EPS recalculated:
  • Normal Economy: $25,000 / 3,000 shares = $8.33/share; Increase = 66.6%
  • Expansion: $31,250 / 3,000 shares = $10.42/share; Increase = 108.4%
  • Recession: $12,500 / 3,000 shares = $4.17/share; Increase = 66.8%

Observation: Recapitalization leads to significantly higher EPS in all scenarios due to share buyback, amplifying the impact of economic changes.

2. EPS with Taxes (25% Tax Rate):

a) Before Recapitalization:

• Taxable income: Adjust EBIT for taxes (EBIT * (1 - Tax Rate))

  • Normal Economy: $25,000 * (1 - 0.25) = $18,750
  • Expansion: $31,250 * (1 - 0.25) = $23,437.50
  • Recession: $12,500 * (1 - 0.25) = $9,375

• Net income: Subtract taxes from taxable income

  • Normal Economy: $18,750 - $4,687.50 (taxes) = $14,062.50
  • Expansion: $23,437.50 - $5,859.38 (taxes) = $17,578.12
  • Recession: $9,375 - $2,343.75 (taxes) = $7,031.25

• EPS recalculated: Divide net income by outstanding shares

  • Normal Economy: $14,062.50 / 5,000 shares = $2.81/share
  • Expansion: $17,578.12 / 5,000 shares = $3.52/share; Increase = 25%
  • Recession: $7,031.25 / 5,000 shares = $1.41/share; Decrease = 50%

b) After Recapitalization: Similar calculations with adjusted outstanding shares (3,000).

3. Stock Dividend Effect on Equity Accounts:

• Total dividend declared: 15% * $45/share * 5,000 shares = $33,750
• Decrease in retained earnings: $33,750
• Increase in common stock: Number of shares issued = Dividend / Market value per share = $33,750 / $45 = 750 shares
• No change in total equity: Decrease in retained earnings balanced by increase in common stock.

4. Sangria Corporation's WACC:

• Weight of equity: 65%
• Weight of debt: 35%
• Cost of equity: 16%
• After-tax cost of debt: 6% * (1 - 0.25) = 4.5%

Sample Solution

. Earnings per Share (EPS) and Recapitalization:

a) Before Recapitalization:

• Normal Economy: EPS = $25,000 / 5,000 shares = $5/share
• Expansion: EBIT = $25,000 * (1 + 25%) = $31,250; EPS = $31,250 / 5,000 shares = $6.25/share; Change = 25% increase