Wild Side, Inc., has no debt outstanding and a total market value of $200,000. Earnings before interest and taxes, EBIT, are projected to be $25,000 if economic conditions are normal.
If there is strong expansion in the economy, then EBIT will be 40 percent higher. If there is a recession, then EBIT will be 60 percent lower.
Wild Side is considering a $70,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 4,000 shares outstanding. Ignore taxes for this problem.
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 Wild Side goes through with recapitalization. What do you observe?