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Caledon has two million shares outstanding and no debt. Earnings before interest and tax (EBIT) are projected to be R15 million under normal conditions, R5 million for a downturn in the economic environment, and R20 million for an economic expansion. Caledon considers a debt issue of R50 million with an 8 percent interest rate. The proceeds would be used to buy back one million shares at the current market price of R50 a share. The corporate tax rate is 40 percent.
Problem 1: Calculate Caledon's earnings per share (EPS) and return on investment (EPS divided by share price) under the two scenarios, first before any new debt is issued and then after the recapitalization.
Problem 2: From your answers to part 1, would you recommend that Caledon goes ahead with the recapitalization?
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