1. EBIT, Taxes, and Leverage. Kaelea, Inc. has no debt outstanding and a total market value of $90,000. Earnings before interest and taxes, EBIT, are projected to be $8,000 if the economic conditions are normal. If there is a strong expansion in the economy, then EBIT will be 20 percent higher. If there is a recession, then EBIT will be 35 percent lower. Kaelea is considering a $34,000 debt issue with a 6 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 3,600 shares outstanding (Complete a. & b. assuming Kaelea has a tax rate: 35%).
- 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.
- Repeat part (a) assuming that Kaelea goes through with recapitalization. What do you observe?