CHAPTER 16

Solutions to Questions and Problems

Basic

1. a. A table outlining the income statement for the three possible states of the economy
is shown below. The EPS is the net income divided by the 5,000 shares
outstanding. The last row shows the percentage change in EPS the company will
experience in a recession or an expansion economy.

Recession Normal Expansion

EBIT $12,600 $21,000 $26,250
Interest 0 0 0
NI $12,600 $21,000 $26,250
EPS $ 2.52 $ 4.20 $ 5.25
%EPS 40 +25

b. If the company undergoes the proposed recapitalization, it will repurchase:

Share price = Equity / Shares outstanding

Share price = $275,000/5,000
Share price = $55

Shares repurchased = Debt issued / Share price

Shares repurchased =$99,000/$55
Shares repurchased = 1,800
Shares outstanding = 5,000 1,800 = 3,200

The interest payment each year under all three scenarios will be:

Interest payment = $99,000(.08) = $7,920

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 The last row shows the percentage change in EPS the company will experience in a
recession or an expansion economy under the proposed recapitalization.

Recession Normal Expansion

EBIT $12,600 $21,000 $26,250
Interest 7,920 7,920 7,920
NI $ 4,680 $13,080 $18,330
EPS $1.46 $ 4.09 $ 5.73
%EPS 64.3 +40

2. a. A table outlining the income statement with taxes for the three possible states of the
economy is shown below. The share price is $55, and there are 5,000 shares
outstanding. The last row shows the percentage change in EPS the company will
experience in a recession or an expansion economy.

Recession Normal Expansion

EBIT $12,600 $21,000 $26,250
Interest 0 0 0
Taxes 4,410 7,350 9,188
NI $8,190 $13,650 $17,063
EPS $1.64 $2.73 $3.41
%EPS 40 +25

b. A table outlining the income statement with taxes for the three possible states of the
economy and assuming the company undertakes the proposed capitalization is
shown below. The interest payment and shares repurchased are the same as in part
b of Problem 1.

Recession Normal Expansion

EBIT $12,600 $21,000 $26,250
Interest 7,920 7,920 7,920
Taxes 1,638 4,578 6,416
NI $3,042 $8,502 $11,915
EPS $0.95 $2.66 $3.72
%EPS 64,3 +40

Notice that the percentage change in EPS is the same both with and without taxes.

3. a. 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/$275,000

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 The ROE for each state of the economy under the current capital structure and no
taxes is:
Recession Normal Expansion
ROE 4.58% 7.64% 9.55%
%ROE 40 +25

The second row shows the percentage change in ROE from the normal economy.

b. If the company undertakes the proposed recapitalization, the new equity value will
be:

Equity = $275,000 99,000

Equity = $176,000

So, the ROE for each state of the economy is:

ROE = NI/$176,000

Recession Normal Expansion

ROE 2.66% 7.43% 10.41%
%ROE 64.22 +40.14

c. If there are corporate taxes and the company maintains its current capital structure,
the ROE is:

ROE 2.98% 4.96% 6.20%

%ROE 40 +25

If the company undertakes the proposed recapitalization, and there are corporate
taxes, the ROE for each state of the economy is:

ROE 1.73% 4.83% 6.77%

%ROE 64.22 +40.14

Notice that the percentage change in ROE is the same as the percentage change in
EPS. The percentage change in ROE is also the same with or without taxes.

4. a. Under Plan I, the unlevered company, net income is the same as EBIT with no
corporate tax. The EPS under this capitalization will be:

EPS = $750,000/265,000 shares

EPS = $2.83

Under Plan II, the levered company, EBIT will be reduced by the interest payment.
The interest payment is the amount of debt times the interest rate, so:

NI = $750,000 .10($2,800,000)
NI = $470,000

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 And the EPS will be:

EPS = $470,000/185,000 shares

EPS = $2.54

Plan I has the higher EPS when EBIT is $750,000.

b. Under Plan I, the net income is $1,500,000 and the EPS is:

EPS = $1,500,000/265,000 shares

EPS = $5.66

Under Plan II, the net income is:

NI = $1,500,000 .10($2,800,000)
NI = $1,220,000

And the EPS is:

EPS = $1,220,000/185,000 shares

EPS = $6.59

Plan II has the higher EPS when EBIT is $1,500,000.

c. To find the breakeven EBIT for two different capital structures, we simply set the
equations for EPS equal to each other and solve for EBIT. The breakeven EBIT is:

EBIT/265,000 = [EBIT .10($2,800,000)]/185,000

EBIT = $927,500

5. We can find the price per share by dividing the amount of debt used to repurchase shares
by the number of shares repurchased. Doing so, we find the share price is:

Share price = $2,800,000/(265,000 185,000)

Share price = $35.00 per share

The value of the company under the all-equity plan is:

V= $35(265,000 shares) = $9,275,000

And the value of the company under the levered plan is:

V = $35(185,000 shares) + $2,800,000 debt = $9,275,000

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