Questions1: Protos Inc Has No Debt Outstanding And A Total M

Questions1 Protos Inc Has No Debt Outstanding And A Total Market

Questions 1. Protos, Inc., has no debt outstanding and a total market value of $300,000. Earnings before interest and taxes, EBIT, are projected to be $25,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 25 percent higher. If there is a recession, then EBIT will be 50 percent lower. Money is considering a $100,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,000 shares outstanding. Ignore taxes for this problem.

a) 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.

b) Repeat part (a) assuming that Protos goes through with recapitalization. What do you observe?

Paper For Above instruction

The financial decisions a company makes regarding its capital structure significantly influence its earnings per share (EPS) and overall financial health. In the case of Protos, Inc., which initially has no debt, analyzing the impact of introducing debt through leverage provides insights into the potential benefits and risks associated with such a move under different economic scenarios.

Part (a): Calculating EPS before and after recapitalization under no debt scenario

Initially, Protos, Inc. has no debt, a market value of $300,000, and 5,000 shares outstanding. The projected EBIT under normal conditions is $25,000, with variations depending on economic conditions. To calculate EPS, we divide net income by the number of shares outstanding.

Under normal conditions, EBIT equals $25,000, and since taxes are ignored, net income equals EBIT, which is $25,000. The EPS is then:

• EPS = $25,000 / 5,000 shares = $5.00

In case of an economic expansion, EBIT increases by 25%: EBIT = $25,000 x 1.25 = $31,250. EPS becomes:

• EPS = $31,250 / 5,000 = $6.25

During a recession, EBIT decreases by 50%: EBIT = $25,000 x 0.50 = $12,500. EPS then is:

• EPS = $12,500 / 5,000 = $2.50

The percentage change in EPS from normal to expansion is ((6.25 - 5.00) / 5.00) x 100% = 25%. From normal to recession is ((2.50 - 5.00) / 5.00) x 100% = -50%. These figures demonstrate how EPS is sensitive to economic conditions in an unleveraged firm.

Part (b): Effect of debt issuance and recapitalization

Protos considers issuing $100,000 of debt at a 6% interest rate to repurchase shares. The new debt increases the total enterprise value to $400,000, with the debt component at $100,000. The repurchase proceeds suggest that the company will buy back as many shares as possible at the current share price ($60), but given no initial share price is directly specified, an approximation can be made.

Assuming the share price remains at $60 prior to repurchase, the number of shares repurchased is:

• Number of shares repurchased = $100,000 / $60 ≈ 1,666.67 shares

Remaining shares outstanding after repurchase: 5,000 - 1,666.67 ≈ 3,333.33 shares.

Now, with the new debt, net income in each economic scenario must account for interest expenses:

• Interest = $100,000 x 6% = $6,000

Under normal conditions:

• EBIT = $25,000
• Net Income = EBIT - Interest = $25,000 - $6,000 = $19,000
• EPS = $19,000 / 3,333.33 ≈ $5.70

In expansion:

• EBIT = $31,250
• Net Income = $31,250 - $6,000 = $25,250
• EPS = $25,250 / 3,333.33 ≈ $7.58

In recession:

• EBIT = $12,500
• Net Income = $12,500 - $6,000 = $6,500
• EPS = $6,500 / 3,333.33 ≈ $1.95

These calculations show that leverage amplifies profit variability — EPS increases more in expansion and decreases more in recession compared to the no-debt scenario. The percentage change from normal to expansion is ((7.58 - 5.00) / 5.00) x 100% = 51.6%, indicating increased risk and reward with leverage. Similarly, a recession causes a 61% drop in EPS in the leveraged scenario.

Observations: The adoption of leverage increases EPS during good times due to the fixed interest expense spreading over a smaller number of equity shares, thereby magnifying gains. Conversely, in downturns, leverage exacerbates losses, reflecting higher financial risk. Debt amplifies earnings volatility but also may enhance shareholder returns in favorable conditions, highlighting the trade-off between risk and return inherent in leverage strategies.

Conclusion: The decision to leverage should consider the company's risk appetite, economic outlook, and capacity to service debt. While leverage can boost EPS in booming periods, it also increases vulnerability during downturns, which is critical for strategic financial planning.

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