Pendergast, Inc., has no debt outstanding and a total market value of $180,000. Earnings before interest and taxes, EBIT, are projected to be $23,000 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 30 percent lower. Pendergast is considering a $75,000 debt issue with a 7 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 6,000 shares outstanding. Ignore taxes for this problem.
a) find out earnings per share (EPS) under each of the three economic scenarios before any debt is issued. Also find out the percentage changes in EPS when the economy expands or enters a recession.
b) Repeat part (a) assuming that the company goes through with recapitalization. What do you observe?