Effect of Financial Leverage

Fredonia, Inc. has no debt outstanding. The companys earnings before interest and taxes, EBIT, are projected to be $80,000 if economic conditions are in recession. If there is a strong expansion in the economy, then EBIT will be $360,000. Fredonia is considering a $600,000 debt issue with an 8 percent interest rate. The proceeds will be used to repurchase shares of stock. Fredonias shares are selling at $24. There are currently 60,000 shares outstanding. Ignore taxes for this problem.

1. Calculate earnings per share, EPS, under each of the two economic scenarios before any debt is issued.

2. Compute the number of shares repurchased with the debt issued.

3. Compute the number of shares outstanding after the share repurchase.

4. Repeat part (1) assuming that the company goes through with capital restructuring (debt issued).