Question

3 0.25 points Ghost, Inc., has no debt outstanding and a total market value of $308,100. Earnings before interest and taxes, EBIT, are projected to be $46,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 20 percent higher. If there is a recession, then EBIT will be 31 percent lower. The company is considering a $160,000 debt issue with an interest rate of 5 percent. The proceeds will be used to repurchase shares of stock. There are currently 7,900 shares outstanding. Ignore taxes for questions a and b. Assume the company has a market-to-book ratio of 1.0 and the stock price remains constant. 04:47:33 eBook Hint Print References a-1. Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) a-2. Calculate the percentage changes in ROE when the economy expands or enters a 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.) b-1. Assume the firm goes through with the proposed recapitalization. Calculate the return on equity (ROE) under each of the three economic scenarios. (Do not round Intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) b-2. Assume the firm goes through with the proposed recapitalization. Calculate the percentage changes in ROE when the economy expands or enters a 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.)

Answer 1

3)

Before recapitalisation: a-1) Recession 10.30% Normal 14.93% Expansion 17.92% EBIT Less: Interest a-2) Recession -31.00% Expansion 20.00% Profit before tax Less: Tax 0% Net income - Equity ROE % change in ROE Normal Recession Expansion $ 46,000 $ 31,740 $ 55,200 $ $ $ $ 46,000 $ 31,740 $ 55,200 $ $ $ $ 46,000$ 31,740 $ 55,200 $308,100 $ 308,100 $ 308,100 14.93% 10.30% 17.92% -31.00% 20.00% b-1) Recession 16.03% Normal 25.66% Expansion 31.87% b-2) Recession -37.53% Expansion 24.21% After recapitalisation: Normal Recession Expansion EBIT $ 46,000 $ 31,740 $ 55,200 Less: Interest $ 8,000 $ 8,000 $ 8,000 =160000*5% Profit before tax $ 38,000 $ 23,740 $ 47,200 Less: Tax 0% $ $ $ Net income $ 38,000 $ 23,740 $ 47,200 :Equity $ 148,100 $ 148,100 $ 148,100 =308100-160000 ROE 25.66% 16.03% 31.87% % change in ROE -37.53% 24.21% $

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