As Chief Financial Officer of the Uptown Service Corporation (USC), you are considering a recapitalization plan that would convert USC from its current all-equity capital structure to one including substantial financial leverage. USC now has 150,000 shares of common stock outstanding, which are selling for $80.00 each.
The recapitalization proposal is to issue $6,000,000 worth of long-term debt, at an interest rate of 7.0 percent, and use the proceeds to repurchase 75,000 shares of common stock worth $6,000,000. USC's earnings in the next year will depend on the state of the economy.
If there is normal growth, EBIT will be $1,200,000. EBIT will be $600,000 if there is a recession, and EBIT will be $1,800,000 if there is an economic boom. You believe that each economic outcome is equally likely. Assume there are no market frictions such as corporate or personal income taxes.
a. If the proposed recapitalization is adopted, calculate the number of shares outstanding, the per-share price, and the debt-to-equity ratio for USC.
b. Calculate the earnings per share (EPS) and the return on equity for USC shareholders, under all three economic outcomes (recession, normal growth, and boom), for both the current all-equity capitalization and the proposed mixed debt/equity capital structure.
c. Calculate the breakeven level of EBIT, where earnings per share for USC stockholders are the same, under the current and proposed capital structures.
d. At what level of EBIT will USC shareholders earn zero EPS, under the current and the proposed capital structures?