Question

Kaelea, Inc., has no debt outstanding and a total market value of $90,000. Earnings before interest and taxes, EBIT, are projected to be $8,900 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 24 percent higher. If there is a recession, then EBIT will be 31 percent lower. The company is considering a $29,000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 4,500 shares outstanding. Assume the company has a market-to-book ratio of 1.0. a. Calculate return on equity, ROE, under each of the three economic scenarios before any debt is issued, assuming no taxes. (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) ROE 6.82.0 Recession Normal 9.89 Expansion 12.26 b. Calculate the percentage changes in ROE when the economy expands or enters a recession, assuming no taxes. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answers as a percent rounded to the nearest whole number, e.g., 32.) %AROE -31 Recession Expansion 24

Answer 1

Affter recapitalisation: Normal Expansion Normal Expansion Particulars Recession Particulars Recession $6,141 $8,900 $6,141 $11,036 $8,900 $11,036 EBIT EBIT less: $0 $0 $0 $2,030 $2,030 $2,030 less: Interest Interest $6,141 $8,900 $11,036 $4,111 $0 $6,870 $9,006 ЕВT ЕВT less: $0 $0 $0 $0 $0 less: Таx Tax $6,870 $61,000 $6,141 $8,900 $11,036 $4,111 $9,006 Net income Net income $90,000 12.26% $61,000 $61,000 $90,000 $90,000 Equity ROE (net income/equity) Equity a) ROE (net income/equity) c) 6.74% 11.26% 6.82% 9.89% 14.76% b) percentage change in ROE Recession Expansion percentage change in ROE Recession d) |(6.82-9.89)/9.89 (12.26-9.89)/9.89 -40.16%| (6.74-11.26)/11.26 31.09% (14.76-11.26)/11.26 -31.00% Expansion 24.00%

Affter recapitalisation: Normal Expansion $11,036 $2,030 $9,006 Normal Expansion Particulars Recession Particulars Recession $6,141 $8,900 $11,036 $6,141 $8,900 EBIT EBIT less: $2,030 $0 $0 $0 $2,030 Interest Interest less: $6,141 $8,900 $2,456 $3,560 $11,036 $4,111 $6,870 ЕВT ЕВТ $1,644 $2,467 $2,748 $4,122 $4,414 $6,622 $3,602 less: less: Tax @ 40% Tax @ 40% $3,685 $5,340 $5,404 Net income Net income $61,000 $90,000 $90,000 $90,000 $61,000 $61,000 Equity Equity e) f) ROE (net income/equity) ROE (net income/equity) 4.09% 5.93% 7.36% 4.04% 6.76% 8,86% percentage change in ROE Recession percentage change in ROE: Recession Expansion -31.00% (3.87-5.69)/5.69 |(7.00-5.69)/5.69 -40.16%| (4.04-6.76)/6.76 31.09%| (8.86-6.76)/6.76 Expansion 24.00%