Pendergast, Inc., has no debt outstanding and has a total market value of $180,000. Earnings before interest and taxes (EBIT) are projected to be $23,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 20% higher. If there is a recession, then EBIT will be 30% lower. Pendergast is considering a $75,000 debt issue with a 7% interest rate. The proceeds will be used to repurchase shares of stock. There are currently 6,000 shares of stock outstanding, and the relevant tax rate is 35%.
a- Calculate ROE and EPS under each of the economic scenarios before any debt is issued.
b- Repeat part a, assuming that the company goes through with the capitalization.
c- Calculate the percentage changes in EPS when the economy expands or enters a recession.
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