Sunrise, Inc., has no debt outstanding and a total market value of $150,000. Earnings before interest and
taxes, EBIT, are projected to be $28,000 if economic conditions are normal. If there is stron

Question

Sunrise, Inc., has no debt outstanding and a total market value of $150,000. Earnings before interest and
taxes, EBIT, are projected to be $28,000 if economic conditions are normal. If there is strong expansion in
the economy, then EBIT will be 20 percent higher. If there is a recession, then EBIT will be 25 percent
lower. The company is considering a $60,000 debt issue with an interest rate of 7 percent. The proceeds
will be used to repurchase shares of stock. There are currently 10,000 shares outstanding. Ignore taxes for
this problem. Assume the stock price is constant under all scenarios.

a-1. Calculate earnings per share (EPS) under each of the three economic scenarios before any debt is
issued. (Do not round intermediate calculations and round your answers to 2 decimal places,
e.g. 32.16.)

a-2. Calculate the percentage changes in EPS when the economy expands or enters a recession. (A
negative answer should be indicated by a minus sign. Do not round intermediate calculations
and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

b-1. Calculate earnings per share (EPS) under each of the three economic scenarios assuming the
company goe

VIPSolutions · Accepted Answer

Let's go through the calculations step-by-step:

---

### Given Data:
- Market value = \$150,000
- Earnings before interest and taxes (EBIT) = \$28,000 (normal)
- Projected EBIT in recession = 20% lower
- Projected EBIT in expansion = 25% higher
- Debt = \$60,000
- Interest rate = 7%
- Shares outstanding = 10,000
- No taxes considered

---

### Step 1: Calculate EBIT under different scenarios

**Recession EBIT:**
$$
EBIT_{recession} = 28,000 \times (1 - .20) = 28,000 \times .80 = 22,400
$$

**Expansion EBIT:**
$$
EBIT_{expansion} = 28,000 \times (1 + .25) = 28,000 \times 1.25 = 35,000
$$

---

### Step 2: Calculate interest expense
$$
Interest = \$60,000 \times .07 = \$4,200
$$

---

### Step 3: Calculate Net Income (Earnings After Interest)

**Recession:**
$$
Earnings_{recession} = EBIT_{recession} - Interest = 22,400 - 4,200 = 18,200
$$

**Normal:**
$$
Earnings_{normal} = 28,000 - 4,200 = 23,800
$$

**Expansion:**
$$
Earnings_{expansion} = 35,000 - 4,200 = 30,800
$$

---

### Step 4: Calculate Earnings Per Share (EPS)

$$
EPS = \frac{\text{Earnings after interest}}{\text{Shares outstanding}} = \frac{\text{Earnings}}{10,000}
$$

**Recession EPS:**
$$
\frac{18,200}{10,000} = 1.82
$$

**Normal EPS:**
$$
\frac{23,800}{10,000} = 2.38
$$

**Expansion EPS:**
$$
\frac{30,800}{10,000} = 3.08
$$

---

### Step 5: Calculate percentage changes in EPS

**Recession percentage change:**
$$
\frac{(1.82 - 2.38)}{2.38} \times 100 = -23.53\%
$$

**Expansion percentage change:**
$$
\frac{(3.08 - 2.38)}{2.38} \times 100 = 29.41\%
$$

---

### Final Results:

| **Scenario** | **EPS** | **Percentage change in EPS** |
|--------------|---------|------------------------------|
| **Recession EPS** | 1.82 | -23.53% |
| **Normal EPS** | 2.38 | N/A |
| **Expansion EPS** | 3.08 | 29.41% |

---

**Note:** The percentage changes are rounded to two decimal places as requested.

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