Castle, Inc., has no debt outstanding and a total market value
of $240,000. Earnings before interest and taxes, EBIT, are
projected to be $36,000 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 25 percent
lower. The firm is considering a debt issue of $155,000 with an
interest rate of 6 percent. The proceeds will be used to repurchase
shares of stock. There are currently 6,000 shares outstanding.
Ignore taxes for questions a and b. Assume the stock price remains
constant.
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. (A negative answer
should be indicated by a minus sign. Do not round intermediate
calculations. Enter your answers as a percent rounded to the
nearest whole number, e.g., 32.)
% 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. (A negative answer
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.
Formula sheet
A | B | C | D | E | F | G | H | I | J | |||||
2 | a-1) | |||||||||||||
3 | Using the following Data: | |||||||||||||
4 | Market Value of Equity before debt issue | 240000 | ||||||||||||
5 | EBIT (Normal) | 36000 | ||||||||||||
6 | % change in case of expansion | 0.2 | ||||||||||||
7 | % change in case of recession | -0.25 | ||||||||||||
8 | Tax rate | 0 | ||||||||||||
9 | Using the above data, since debt and taxes are zero, therefore net income can be calculated as following: | |||||||||||||
10 | ||||||||||||||
11 | EBIT | Interest Expense | Income Before Tax | Tax Expense | Net Income | |||||||||
12 | Recession | =D13*(1+D7) | 0 | =D12-E12 | =F12*$D$8 | =F12-G12 | =F12-G12 | |||||||
13 | Normal | =D5 | 0 | =D13-E13 | =F13*$D$8 | =F13-G13 | ||||||||
14 | Expansion | =D5*(1+D6) | 0 | =D14-E14 | =F14*$D$8 | =F14-G14 | ||||||||
15 | ||||||||||||||
16 | Return on Equity calculation: | |||||||||||||
17 | Return on Equity is given by following formula: | |||||||||||||
18 |
|
|||||||||||||
19 | ||||||||||||||
20 | ||||||||||||||
21 | ||||||||||||||
22 | Since preferred dividend is zero, Return on Equity can be calculated as follows: | |||||||||||||
23 | ||||||||||||||
24 | Net Income | Shareholder's Equity | Return on Equity | |||||||||||
25 | Recession | =H12 | =$D$4 | =D25/E25 | =D25/E25 | |||||||||
26 | Normal | =H13 | =$D$4 | =D26/E26 | ||||||||||
27 | Expansion | =H14 | =$D$4 | =D27/E27 | ||||||||||
28 | ||||||||||||||
29 | a-2) | |||||||||||||
30 | ||||||||||||||
31 | % change in ROE | |||||||||||||
32 | Recession | =(F25-F26)/F26 | =(F25-F26)/F26 | |||||||||||
33 | Expansion | =(F27-F26)/F26 | ||||||||||||
34 | ||||||||||||||
35 | b-1) | |||||||||||||
36 | Market Value before Debt Issue | 240000 | ||||||||||||
37 | Debt Issued | 155000 | ||||||||||||
38 | Market Value after debt Issue | =D36-D37 | ||||||||||||
39 | ||||||||||||||
40 | Interest Rate | 0.06 | ||||||||||||
41 | Interest Expense | =D37*D40 | ||||||||||||
42 | Tax Rate | 0 | ||||||||||||
43 | ||||||||||||||
44 | Using the above data, net income can be calculated as following: | |||||||||||||
45 | ||||||||||||||
46 | EBIT | Interest Expense | Income Before Tax | Tax Expense | Net Income | |||||||||
47 | Recession | =D12 | =$D$41 | =D47-E47 | =F47*$D$42 | =F47-G47 | =F47-G47 | |||||||
48 | Normal | =D13 | =$D$41 | =D48-E48 | =F48*$D$42 | =F48-G48 | ||||||||
49 | Expansion | =D14 | =$D$41 | =D49-E49 | =F49*$D$42 | =F49-G49 | ||||||||
50 | ||||||||||||||
51 | Return on Equity calculation: | |||||||||||||
52 | Return on Equity is given by following formula: | |||||||||||||
53 |
|
|||||||||||||
54 | ||||||||||||||
55 | ||||||||||||||
56 | ||||||||||||||
57 | Since preferred dividend is zero, Return on Equity can be calculated as follows: | |||||||||||||
58 | ||||||||||||||
59 | Net Income | Shareholder's Equity | Return on Equity | |||||||||||
60 | Recession | =H47 | =$D$38 | =D60/E60 | =D60/E60 | |||||||||
61 | Normal | =H48 | =$D$38 | =D61/E61 | ||||||||||
62 | Expansion | =H49 | =$D$38 | =D62/E62 | ||||||||||
63 | ||||||||||||||
64 | b-2) | |||||||||||||
65 | ||||||||||||||
66 | % change in ROE | |||||||||||||
67 | Recession | =(F60-F61)/F61 | =(F60-F61)/F61 | |||||||||||
68 | Expansion | =(F62-F61)/F61 | ||||||||||||
69 |
Castle, Inc., has no debt outstanding and a total market value of $240,000. Earnings before interest...
Castle, Inc., has no debt outstanding and a total market value of $240,000. Earnings before interest and taxes, EBIT, are projected to be $28,000 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 25 percent lower. The firm is considering a debt issue of $140,000 with an interest rate of 6 percent. The proceeds will be used to repurchase shares...
Castle, Inc., has no debt outstanding and a total market value of $200,000. Earnings before interest and taxes, EBIT, are projected to be $24,000 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. The firm is considering a debt issue of $70,000 with an interest rate of 7 percent. The proceeds will be used to repurchase shares...
RAK, Inc., has no debt outstanding and a total market value of $240,000. Earnings before interest and taxes, EBIT, are projected to be $26,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 18 percent higher. If there is a recession, then EBIT will be 20 percent lower. RAK is considering a $150,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock....
RAK, Inc., has no debt outstanding and a total market value of $240,000. Earnings before interest and taxes, EBIT, are projected to be $26,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 18 percent higher. If there is a recession, then EBIT will be 20 percent lower. RAK is considering a $150,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock....
RAK, Inc., has no debt outstanding and a total market value of $240,000. Earnings before interest and taxes, EBIT, are projected to be $26,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 18 percent higher. If there is a recession, then EBIT will be 20 percent lower. RAK is considering a $150,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock....
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....
RAK, Inc., has no debt outstanding and a total market value of $240,000. Earnings before interest and taxes, EBIT, are projected to be $26,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 18 percent higher. If there is a recession, then EBIT will be 20 percent lower. RAK is considering a $150,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock....
RAK, Inc., has no debt outstanding and a total market value of $240,000. Earnings before interest and taxes, EBIT, are projected to be $26,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 18 percent higher. If there is a recession, then EBIT will be 20 percent lower. RAK is considering a $150,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock....
Music City, Inc., has no debt outstanding and a total market value of $240,000. Earnings before interest and taxes, EBIT, are projected to be $28,000 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 25 percent lower. The company is considering a $140,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares...
RAK, Inc., has no debt outstanding and a total market value of $250,000. Earnings before interest and taxes, EBIT, are projected to be $40,000 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 20 percent lower. RAK is considering a $105,000 debt issue with an interest rate of 4 percent. The proceeds will be used to repurchase shares of stock....