As Chief Financial Officer of the Campus Supply Corporation (CSC), you are considering a recapitalization plan that would convert CSC from its current all-equity capital structure to one including substantial financial leverage. CSC now has 250,000 shares of common stock outstanding, which are selling for $60.00 each, and the recapitalization proposal is to issue $7,500,000 worth of long-term debt at an interest rate of 6.0 percent and use the proceeds to repurchase 125,000 shares of common stock worth $7,500,000. CSC’s earnings next year will depend on the state of the economy. If there is normal growth, EBIT will be $2,000,000; EBIT will be $1,000,000 if there is a recession and EBIT will be $3,000,000 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. Calculate the number of shares outstanding, the per-share price and the debt-to-equity ratio for CSC if the proposed recapitalization is adopted.
b. Calculate the expected earnings per share (EPS) and return on equity for CSC 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 break-even level of EBIT where earnings per share for CSC stockholders are the same under the current and proposed capital structures.
d. At what level of EBIT will CSC shareholders earn zero EPS under the current and the proposed capital structures?

  • CreatedMarch 26, 2015
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