Description
Question 1
Wing Air, Inc. has no debt outstanding and a total market value of $250,000. Earnings before interest and taxes (EBIT) are projected to be $25,000 if economic conditions are normal. If the economy is strong then EBIT will be 20% percent higher. In the event of a recession, EBIT will be 35% percent lower. Wing Air is considering a $96,000 debt issue with an interest rate of 6% percent. The proceeds of which will be used to repurchase shares of stock. There are currently 6,000 shares outstanding. Ignore taxes for this problem.
Calculate the earnings per share (EPS) under each of the three scenarios before any debt is issued.
Calculate the percentage change in EPS when the economy expands or enters a recession.
Market value $250,000
EBIT $25,000
Expansion-EBIT 20%
Recession-EBIT 35%
Debt issue $96,000
Interest rate 6%
Shares outstanding 6,000
Question 2
Wing Air, Inc. has no debt outstanding and a total market value of $250,000. Earnings before interest and taxes (EBIT) are projected to be $25,000 if economic conditions are normal. If the economy is strong then EBIT will be 20% percent higher. In the event of a recession, EBIT will be 35% percent lower. Wing Air is considering a $96,000 debt issue with an interest rate of 6% percent. The proceeds of which will be used to repurchase shares of stock. There are currently 6,000 shares outstanding.
Calculate the earnings per share (EPS) under each of the three scenarios before any debt is issued. Assume a 30% tax rate.
Calculate the percentage change in EPS when the economy expands or enters a recession. Assume a 30% tax rate.
Question 3
Air Taxi, Inc. and Wing Air, Inc. are identical in every way, except that Wing Air is a more levered firm. Both companies expect to remain in business for one more year. Here are the economist projections for the next year:
Probability of expansion 75%
Probability of recession 25%
Expansion EBIT $3,700,000
Recession EBIT $2,100,000
Air Taxi debt payment $850,000
Wing Air debt payment $1,300,000
Annual discount rate 12%
What is the value of each firm’s debt and equity?
Question 4
Cavu Air, Inc. has $3,500,000 in excess cash. They plan to use this cash to retire its outstanding debt or repurchase equity. The bank that holds the debt is willing to sell it back to Cavu for $3,500,000 and not charge any transaction fees. Once Cavu becomes an all equity firm, it will stay unlevered in perpetuity. If they do not retire the debt, the company will use the $3,500,000 to buy back some of its stock from the market. This also has no transaction fees. Regardless of capital structure, the firm will generate $1,500,000 of annual earnings before interest and taxes in perpetuity. At the end of each year, the company immediately pays out all earnings as dividends. The corporate tax rate is 35% and the required rate of return is 20% The personal tax rate on the interest income is 25% and there are no taxes on equity distribution. Assume no bankruptcy costs. Answer the following:
What is the value of Cavu, if it decides to retire all of its debt and become an unlevered firm?
What is the value of Cavu, if it decides to repurchase stock instead of retiring its debt?
Assume, that expected bankruptcy costs have a present value of $450,000 How does this influence Cavu’s decision?
Excess cash $3,500,000
Annual EBIT $1,500,000
Corporate tax rate 35%
Unlevered cost of equity 20%
Interest income tax rate 25%
Bankruptcy costs $450,000