Eastern Markets has no debt outstanding and a total market value of $346,500. Earnings before interest and taxes, EBIT, are projected to be $14,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 13 percent higher. If there is a recession, then EBIT will be 32 percent lower. The firm is considering a debt issue of $16,000 with an interest rate of 6.8 percent. The proceeds will be used to repurchase shares of stock. There are currently 4,500 shares outstanding. Ignore taxes. What will be the percentage change in EPS if the economy enters a recessionary period?
A) −35 percent
B) −41 percent
C) −32 percent
D) −28 percent
E) −30 percent

Question

Quizplus · Accepted Answer

The correct answer is A.The percentage change in EPS if the economy enters a recessionary period is -35%. This is calculated as follows:EPS without debt = EBIT / Number of shares outstanding= $14,000 / 4,500= $3.11EPS with debt = (EBIT - Interest expense) / (Number of shares outstanding - Shares repurchased)= ($14,000 - $16,000 * 0.068) / (4,500 - 16,000 / $3.11)= $2.02Percentage change in EPS = (EPS with debt - EPS without debt) / EPS without debt= ($2.02 - $3.11) / $3.11= -35%

Eastern Markets Has No Debt Outstanding and a Total Market