Question

Castle, Inc., has no debt outstanding and a total market value of $240,000. Earnings before interest and taxes, EBIT, are projected to be $26,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 18 percent higher. If there is a recession, then EBIT will be 20 percent lower. The firm is considering a debt issue of $150,000 with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 15,000 shares outstanding. Ignore taxes for questions a and b. Assume the stock price remains constant. a-1. Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

Normal:

EBIT = $26,000

Recession:

EBIT = $26,000 - 20% * $26,000
EBIT = $20,800

Expansion:

EBIT = $26,000 + 18% * $26,000
EBIT = $30,680

Answer a-1.

Total Value = $240,000

Value of Equity = Total Value
Value of Equity = $240,000

EBIT Less: Interest Expense EBT Less: Taxes Net Income Value of Equity Return on Equity Recession $ 20,800 $ $ - $ $ 20,800 $ $ $ 20,800 $ $ 240,000 $ 8.67% Normal Expansion 26,000 $ 30,680 - $ 26,000$ 30,680 $ 26,000$ 30,680 240,000 $ 240,000 10.83% 12.78% IS