Question

As CFO of Duke Corp., you are considering a recapitalization plan that would convert Duke Corp. from its current all-equity capital structure to one that includes substantial financial leverage. Duke now has 600,000 shares of common stock outstanding, which are selling for $55 each. You expect the firm’s EBIT to be $3,000,000 for the near future. If there is strong expansion in the economy, then EBIT will be 30 percent higher. If there is a recession, then the EBIT will be 40 percent lower.

The recapitalization proposal is to issue $8,250,000 worth of long-term debt, at an interest rate of 6.0 %, and then to use the proceeds to repurchase 150,000 shares of common stock worth $8,250,000. Assuming there are no market frictions such as corporate or personal income taxes,

(a) Calculate the expected ROE and EPS for Duke Corp under each of the three economic scenarios before any debt issue using the table below

Cash Flows to Stockholders and Bondholders Under Current Capital Structure
	Recession	Normal	Expansion
EBIT
Interest (6.0%)
Net income
Shares outstanding
Earnings per share
Return on equity (P0 = $55.00/sh)

(b) Repeat part (a) assuming that the company goes through with recapitalization using the table

Cash Flows to Stockholders and Bondholders Under Proposed Recapitalization
	Recession	Normal	Expansion
EBIT
Interest (6.0%)
Net income
Shares outstanding
Earnings per share
Return on equity (P0 = $55.00/sh)