1. EBIT, Taxes, and Leverage. Kaelea, Inc. has no debt outstanding and a total market value of $90,000. Earnings before interest and taxes, EBIT, are projected to be $8,000 if the economic conditions are normal. If there is a strong expansion in the economy, then EBIT will be 20 percent higher. If there is a recession, then EBIT will be 35 percent lower. Kaelea is considering a $34,000 debt issue with a 6 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 3,600 shares outstanding (Complete a. & b. assuming Kaelea has a tax rate: 35%).
- Calculate earnings 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.
- Repeat part (a) assuming that Kaelea goes through with recapitalization. What do you observe?
2. Calculating WACC. Crosby Industries has a debt-equity ratio of 1.5. Its WACC is 9 percent, and its cost of debt is 6 percent. There is no corporate tax.
a. What is Crosby's cost of equity capital?
b. What would the cost of equity be if the debt-equity ratio were 2.0?
c. What if it were 0.5? What if it were zero?
3. Dividends and Stock Prices. Your portfolio is 180 shares of Sunny Morning, Inc. The stock currently sells for $88 per share. The company has announced a dividend of $1.90 per share with an ex-dividend date of April 19. Assuming no taxes, how much will your stocks be worth on April 19? It is April 19, what is your total portfolio value?
4. Stock Dividends. The owners' equity account ts for Trans World International are shown here:
Common stock ($1 par value) $30,000
Capital surplus 185,000
Retained earnings 610,000
Total owners' equity $825,000
a. If Trans World stock currently sells for $42 per share and a 10 percent stock dividend is declared, how many new shares will be distributed? Show how the equity accounts would change.
b. If Trans World declared a 25 percent stock dividend, how would the accounts change?