North Side Inc. has no debt outstanding and a total market value of $168,000. Earnings before interest and taxes, EBIT, are projected to be $18,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 22 percent higher. If there is a recession, then EBIT will be 35 percent lower. The company is considering a $50,000 debt issue with an interest rate of 7.4 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,000 shares outstanding and the tax rate is 21 percent. What will be the percentage change in EPS if the economy has a strong expansion?

Question

Quizplus · Accepted Answer

First, calculate the EBIT under strong expansion: $18,000 * 1.22 = $21,960. Then, calculate the interest expense: $50,000 * 0.074 = $3,700. The net income under expansion with debt is then: ($21,960 - $3,700) * (1 - 0.21) = $14,425.8. Without debt, net income under expansion is: $21,960 * (1 - 0.21) = $17,348.4. The number of shares repurchased with $50,000 is $50,000 / ($168,000 / 5,000) = 1,488.1 shares, leaving 3,511.9 shares. The EPS with debt is $14,425.8 / 3,511.9 = $4.11, and without debt, it's $17,348.4 / 5,000 = $3.47. The percentage change in EPS is (($4.11 - $3.47) / $3.47) * 100 = 18.44%. However, given the choices provided do not match the calculated result, it suggests a need to reevaluate the calculation or assumptions made. The correct approach involves comparing the EPS before and after the debt issue under the scenario of a strong expansion, taking into account the interest expense, tax savings from the debt, and the reduced number of shares outstanding after repurchase.