As chief financial officer of 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 each.

The recapitalization proposal is to issue $6,000,000 worth of long-term debt, at an interest rate of 7.0%, 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, cash flow before interest and taxes will be $1,200,000. Cash flow will be $600,000 if there is a recession, and it wil bee $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.

Requirements:

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 EPS and the ROE for USC shareholders, under all three economic outcomes (recession, normal growth, and boom), for both the current all-equity capitalization and the proposed mixed capital structure.

c. Calculate the break-even level of cash flow where earnings per share for USC stockholders are the same under the current and proposed capital structures.

d. At what level of cash flow will USC shareholders earn zero EPS under the current and the proposed capital structures?

Answer rating: 100% (QA)

a No of shares outstanding under the proposed reca... View the full answer