Kaelea, Inc., has no debt outstanding and a total market

value of $194,775. Earnings before interest and taxes, EBIT, are projected to be

$13,800 if 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 35 percent lower. The company is considering a $39,750 debt issue with

an interest rate of 6 percent. The proceeds will be used to repurchase shares of

stock. There are currently 7,350 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 company goes through with recapitalization.

What do you observe? Assume the stock price remains constant.