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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 a 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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