Question

Walker, Inc., has no debt outstanding and a total market value of $180,000. Earnings before interest and taxes, EBIT, are projected to be $19,000 if economic conditions are normal. If there is an expansion in the economy, then EBIT will be $28,000. If there is a recession, then EBIT will be $12,000. Walker is considering a $66,000 debt issue with a 5% interest rate. The proceeds will be used to repurchase shares of stock (this is known as recapitalization). There are currently 3,000 shares outstanding. Walker has a market-to-book ratio of 1.0

1. Calculate return on equity (ROE) under normal economic conditions assuming that the firm goes through with the recapitalization. Assume no taxes. (Answer in percentage terms and round to 2 decimal places. Do not round intermediate calculations.)
   
   
2. Calculate return on equity (ROE) under the economic expansion assuming that the firm goes through with the recapitalization. Assume no taxes. (Answer in percentage terms and round to 2 decimal places. Do not round intermediate calculations.)
   
   
3. Calculate return on equity (ROE) under the economic recession assuming that the firm goes through with the recapitalization. Assume no taxes.

Answer 1

Before recapitalisation
	Recession	Normal	Expansion
EBIT	12000	19000	28000
Less: Interest	0	0	0
EBT	12000	19000	28000
Less: Taxes	0	0	0
Net Income	12000	19000	28000
Equity	180000	180000	180000
ROE	6.67%	10.56%	15.56%
After recapitalisation
	Recession	Normal	Expansion
EBIT	12000	19000	28000
Less: Interest	3300	3300	3300
EBT	8700	15700	24700
Less: Taxes	0	0	0
Net Income	8700	15700	24700
Equity	114000	114000	114000
ROE	7.63%	13.77%	21.67%