XYZ is currently an all-equity firm with a total market value of $1,000,000. Earnings before interest and taxes (EBIT) are projected to be $80,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 20% higher. If there is a recession, then EBIT will be 30% lower. The three states of the economy are equally likely. XYZ is considering a (perpetual) debt issue of $150,000 with an interest (i.e., coupon) rate of 6%. The proceeds will be used to repurchase shares of stock. There are currently 25,000 shares outstanding. Suppose that XYZ pays no taxes (that is, the tax rate is 0%). 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 XYZ goes through with the recapitalization (that is, XYZ issues debt to repurchase shares at the current market price). Explain your findings.
XYZ is currently an all-equity firm with a total market value of $1,000,000. Earnings before
interest and taxes (EBIT) are projected to be $80,000 if economic conditions are normal. If
there is strong expansion in the economy, then EBIT will be 20% higher. If there is a
recession, then EBIT will be 30% lower. The three states of the economy are equally
likely. XYZ is considering a (perpetual) debt issue of $150,000 with an interest (i.e.,
coupon) rate of 6%. The proceeds will be used to repurchase shares of stock. There are
currently 25,000 shares outstanding. Suppose that XYZ pays no taxes (that is, the tax rate
is 0%).
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 XYZ goes through with the recapitalization (that is,
XYZ issues debt to repurchase shares at the current market price). Explain your
findings.
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