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The finance manager of the GZA Ltd is considering a recapitalization plan that would convert GZA from its current all-equity capital structure to one including substantial financial leverage. GZA now has 10,000,000 ordinary shares outstanding, which are selling for $15 each, and the company's EBIT is expected to be $12,000,000 per year for the foreseeable future. The recapitalization proposal is to issue $60,000,000 worth of long-term, perpetual debt at an annual interest rate of 3.0% and use the proceeds to repurchase 4,000,000 ordinary shares worth $60,000,000. Assume perfect capital markets with no market frictions such as corporate or personal income taxes.
Problem 1: Calculate the earnings per share and expected return on equity for GZA's shareholders under both the current all-equity capital structure and under the recapitalization plan. Show all calculations.
Problem 2: Calculate the breakeven level of EBIT where the earnings per share are the same under the current and proposed capital structures. Show all calculations.
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