North Side, Inc. has no debt outstanding and a total market value of $175,000. Earnings before interest and taxes, EBIT, are projected to be $16,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 35 percent higher. If there is a recession, then EBIT will be 70 percent lower. North Side is considering a $70,000 debt issue with a 7 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 2,500 shares outstanding. North Side has a tax rate of 34 percent. If the economy expands strongly, EPS will change by ____ percent as compared to a normal economy, assuming that the firm recapitalizes.

Question

Quizplus · Accepted Answer

Share price = $175,000/2,500 = $70Shares repurchased = $70,000/$70 = 1,000Annual interest = $70,000 F1F1F1S1F1F1F10 0.07 = $4,900EPS _Normal = [($16,000 - $4,900)(1 - 0.34)]/(2,500 - 1,000) = $4.884EPS _Expansion = (expression error)/(2,500 - 1,000) = $7.348Percentage change = ($7.348 - $4.884)/$4.884 = 50.45 percent