Question 1

Question 1 (a) An all equity rm has the following expectations about earnings this year State Recession Normal Expansion Earnings (m) 1.5 2 2.5 Assume that each state of the economy has an equal probability of occurring this year and that the rm pays no taxes. The firm has 5 million shares outstanding (i) Calculate the earnings per share (EPS), in each state of the economy, and calculate the expected earnings this year. (5 marks) (ii) Calculate the variance and the standard deviation of this rm's EPS (5 marks) (b) Now assume that the rm has issued 5 million worth of debt, and used the proceeds from the debt issue to repurchase half of its shares. Assume that the return on debt is 10%. (i) Calculate the earnings per share (EPS), in each state of the economy, and calculate the expected earnings this year after the repurchase. (10 marks) (ii) Calculate the variance and the standard deviation of this rms EPS (5 marks) (0) Compare your results for parts (a)(ii) and (b)(ii) above and explain if, and how, they differ and explain why this is the case. (10 marks) (d) Explain what is meant by the term 'nancial distress'. If we assume that nancial distress exists, explain how and why nancial distress would cause a rm's equity to become more risky. (7 marks) (e) What were the primary causes of the nancial distress experienced by the Arcadia group? (8 marks)