Question

Kaelea, Inc., has no debt outstanding and a total market value of $75,000. Earnings before interest and taxes, EBIT, are projected to be $9,400 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 $22,500 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,000 shares outstanding. Assume the company has a market-to-book ratio of 1.0. Assume the firm has a tax rate of 35 percent. e. Calculate return on equity, ROE, under each of the three economic scenarios before any debt is issued. Also, calculate the percentage changes in ROE for economic expansion and recession. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) ROE Recession % Normal % Expansion % %ΔROE Recession % Expansion % f. Calculate return on equity, ROE, under each of the three economic scenarios after the recapitalization. Also, calculate the percentage changes in ROE for economic expansion and recession, assuming the firm goes through with the proposed recapitalization. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) ROE Recession % Normal % Expansion % %ΔROE Recession % Expansion %

Answer 1

Before recapitalisation: e) Recession 5.62% Normal 8.15% Expansion 10.10% EBIT Less: Interest Profit before tax Less: Tax 35% Recession -31.00% Expansion 24.00% Normal Recession Expansion $ 9,400 $ 6,486 $ 11,656 $ - $ - $ - $ 9,400 $ 6,486 $ 11,656 ($ 3,290 $ 2,270 $ 4,080 $ 6,110 $ 4,216 $ 7,576 $ 75,000 $ 75,000 $ 75,000 8.15% 5.62% 10.10% -31.00% 24.00% Net income - Equity ROE Recession Normal Expansion 5.80% 9.41% 12.20% % change in ROE Recession -38.34% Expansion 29.68% =22500*8% | After recapitalisation: Normal Recession Expansion EBIT $ 9,400 $ 6,486 $ 11,656 Less: Interest | $ 1,800 $ 1,800 $ 1,800 Profit before tax $ 7,600 $ 4,686 $ 9,856 Less: Tax 35% $ 2,660 $ 1,640$ 3,450 Net income $ 4,940 $ 3,046 $ 6,406 Equity | $ 52,500 $ 52,500 $ 52,500 ROE 9.41% 5.80% 12.20% % change in ROE -38.34% 29.68% = 75000-22500

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