Question

RAK, Inc., has no debt outstanding and a total market value of $240,000. Earnings before interest and taxes, EBIT, are projected to be $32,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 15 percent higher. If there is a recession, then EBIT will be 30 percent lower. RAK is considering a $80,000 debt issue with an interest rate of 7 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 company has a market-to-book ratio of 1.0. 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.) ROE Recession Normal Expansion a-2 Calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) Recession Expansion % change in ROE -30% 15 % Assume the firm goes through with the proposed recapitalization. b-1 Calculate the return on equity (ROE) under each of the three economic scenarios. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) ROE Recession Normal Expansion b-2 Calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) % change in ROE Recession Expansion Assume the firm has a tax rate of 35 percent. C-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.) ROE Recession Normal Expansion

Answer 1

	Recession	Normal	Expansion
EBIT	22,400	32,000	36,800
Less: Interest	0	0	0
Earnings before taxes	22,400	32,000	36,800
Less: Taxes	0	0	0
Net Income	22,400	32,000	36,800
ROI	9.33%	13.33%	15.33%
% change
Recession = (9.33-13.33)/13.33	-30.00%
Expansion	15.00%
b-1
	Recession	Normal	Expansion
EBIT	22,400	32,000	36,800
Less: Interest	5600	5600	5600
Earnings before taxes	16,800	26,400	31,200
Less: Taxes	0	0	0
Net Income	16,800	26,400	31,200
ROI	10.50%	16.50%	19.50%
% change
Recession	-36.36%
Expansion	18.18%

	Recession	Normal	Expansion
EBIT	22,400	32,000	36,800
Less: Interest	0	0	0
Earnings before taxes	22,400	32,000	36,800
Less: Taxes	7,840	11,200	12,880
Net Income	14,560	20,800	23,920
ROI	6.07%	8.67%	9.97%
% change
Recession = (9.33-13.33)/13.33	-30.00%
Expansion	15.00%
c-3
	Recession	Normal	Expansion
EBIT	22,400	32,000	36,800
Less: Interest	5600	5600	5600
Earnings before taxes	16,800	26,400	31,200
Less: Taxes	5,880	9,240	10,920
Net Income	10,920	17,160	20,280
ROI	6.83%	10.73%	12.68%
% change
Recession	-36.36%
Expansion	18.18%