*ALREADY ANSWERED THIS PART*Leverage. Castle, Inc., has no debt outstanding and a total market value of $305,000. Earnings before interest and taxes, EBIT, are projected to be $26,000 if the economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 20 percent higher. If there is a recession, then EBIT will be 25 percent lower. The firm is considering a debt issue of $95,000 with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,000 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 the firm goes through with recapitalization. What do you observe?

QUESTIONS NEEDED: Suppose the firm in Problem 1 has a market-to-book ratio of 1.0.

a. calculate return on equity, ROE, under each other three economic scenarios before any debt is issued. Also, calculate the percentage changes in ROE for economic expansion and recession, assuming no taxes.

b. repeat part (a) assuming the firm goes through with the proposed recapitalization.

Share price $61 =305000/5000 $ a-1) Recession $ 19,500 $ - $ 19,500 $ - $ 19,500 5,000 $ 3.90 1 Before recapitalisation: 2 Normal 4 EBIT $ 26,000 5 Less: Interest 6 Profit before tax $ 26,000 7 Less: Tax 0% $ - 8 Net income $ 26,000 9 Number of shares 5,000 10 EPS $ 5.20 11 12 % change in EPS 13 14 After recapitalisation: Expansion $ 31,200 $ $ 31,200 $ $ 31,200 5,000 $ 6.24 Recession Normal Expansion $ 3.90 $ 5.20 $ 6.24 a-2) Recession Expansion -25.00% 20.00% -25.00% 20.00% b-1) Recession Normal Expansion $ 4.01 $ 5.90 $ 7.41 15 b-2) Recession Expansion -32.02% 25.62% =95000*6% 16 17 EBIT 18 Less: Interest 19 Profit before tax 20 Less: Tax 0% 21 Net income 22 Number of shares 23 EPS Normal $ 26,000 $ 5,700 $ 20,300 $ - $ 20,300 3,443 $ 5.90 Recession Expansion $ 19,500 $ 31,200 $ 5,700 $ 5,700 $ 13,800 $ 25,500 $ - $ $ 13,800 $ 25,500 3,443 3,443 $ 4.01 $ 7.41 =5000-95000/61 24 -32.02% 25.62% 25 % change in EPS 26