Question

RAK, Inc., has no debt outstanding and a total market value of $140,000. 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 12 percent higher. If there is a recession, then EBIT will be 30 percent lower. RAK is considering a $115,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 7,000 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.)

  

	% change in ROE
Recession	%
Expansion	%

  

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	%

  

c-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	%

  

c-3	Calculate the return on equity (ROE) under each of the three economic scenarios assuming the firm goes through with the recapitalization. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

  

	ROE
Recession	%
Normal	%
Expansion	%

  

c-4	Given the recapitalization, calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places. (e.g., 32.16))

  

	% change in ROE
Recession	%
Expansion	%

Answer 1

solution: a 1 economic condition EBITENI ROE= NI/140000 recession 22400 Normal 32000 expansion 35840 16.00% 22.86% 25.60% a2 economic condition %A ROE calculation recession -30.00% (16-22.86)/22.86 expansion 12.00%|(25.6-22.86)/22.86 b1 economic condition EBIT interest 115000*0.06 recession 22400 Normal 32000 expansion 35840 NI=EBIT-Int ROE= NI/(140000-115000) 6900 15500 62.00% 6900 251001 100.40% 6900 289401 115.76% b2 economic condition %AROE calculation recession -38.25% (62-100.4)/100.4 expansion 15.30% (115.76-100.4)/100.4

c1 economic condition EBIT TAX =EBIT*35% recession Normal expansion 22400 32000 35840 7,840.00 11,200.00 12,544.00 NI=EBIT-tax ROE= NI/140000 14,560.00 20,800.00 23,296.00 10.40% 14.86% 16.64% c2 economic condition %AROE calculation recession 1-30.00%|(10.4-14.86)/14.86 expansion 12.00% (16.64-14.86)/14.86 EBT = EBIT-TAX =EBT* 35% FAT c3 economic condition EBIT Interest 115000*0.06 recession 22400 Normal 32000 expansion 35840 6900 6900 6900 15500 251001 289401 5,425 8,785 10,129 EAT=EBT-Tax ROE= NI/(140000-115000) 10,075 40.30% 16,315 65.26% 18,811 75.24% economic condition %A ROE calculation recession -38.25%(40.3-65.26)/65.26 expansion 15.30%(75.24-65.26)/65.26 EBIT=Earning before Interest and tax NI=Net income EBT=Earning before tax EAT=Earning after tax