In: Finance

# Kaelea, Inc., has no debt outstanding and a total market value of $69,000. Earnings before interest... Kaelea, Inc., has no debt outstanding and a total market value of$69,000. Earnings before interest and taxes, EBIT, are projected to be $9,000 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 company is considering a$21,900 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 4,600 shares outstanding. Assume the company has a market-to-book ratio of 1.0.

a. Calculate return on equity, ROE, under each of the three economic scenarios before any debt is issued, assuming no taxes. (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 %

b. Calculate the percentage changes in ROE when the economy expands or enters a recession, assuming no taxes. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answers as a percent rounded to the nearest whole number, e.g., 32.)

 %ΔROE Recession % Expansion %

Assume the firm goes through with the proposed recapitalization and no taxes.

c. Calculate return on equity, ROE, under each of the three economic scenarios after the recapitalization. (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 %

d. 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.)

 %ΔROE Recession % Expansion %

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 %

## Solutions

##### Expert Solution

 a ROE = EBIT*(1-tax rate)/Market value Recession ROE = EBIT*(1-recession impact%)*(1-tax rate)/market value ROE=9000*(1-0.25)*(1-0)/69000 ROE=9.78 Normal ROE = EBIT*(1-tax rate)/Market value ROE=9000*(1-0)/69000 ROE=13.04 Expansion ROE = EBIT*(1+Growth impact%)*(1-tax rate)/Market value ROE=9000*(1+0.2)*(1-0)/69000 ROE=15.65 b %age change in ROE for Recession =(ROE recession/ROE normal-1)*100 =(0.0978/0.1304-1)*100 =-25% %age change in ROE for Growth =(ROE Growth/ROE normal-1)*100 =(0.1565/0.1304-1)*100 =20.02% c New market value = old market value-debt =69000-21900 =47100 ROE = (EBIT-debt*interest%)*(1-tax rate)/new market value Recession ROE = (EBIT*(1-recession impact%)-debt*interest %age)*(1-tax rate)/new market value ROE=(9000*(1-0.25)-21900*0.08)*(1-0)/47100 ROE=10.61 Normal ROE = (EBIT-debt*interest%)*(1-tax rate)/new market value ROE=(9000-21900*0.08)*(1-0)/47100 ROE=15.39 Expansion ROE= (EBIT*(1+growth impact%)-debt*interest %age)*(1-tax rate)/new market value ROE=(9000*(1+0.2)-21900*0.08)*(1-0)/47100 ROE=19.21 d %age change in ROE for Recession =(ROE recession/ROE normal-1)*100 =(0.1061/0.1539-1)*100 =-31.06% %age change in ROE for Growth =(ROE Growth/ROE normal-1)*100 =(0.1921/0.1539-1)*100 =24.82%
 e ROE = EBIT*(1-tax rate)/Market value Recession ROE = EBIT*(1-recession impact%)*(1-tax rate)/market value ROE=9000*(1-0.25)*(1-0.35)/69000 ROE=6.36 Normal ROE = EBIT*(1-tax rate)/Market value ROE=9000*(1-0.35)/69000 ROE=8.48 Expansion ROE = EBIT*(1+Growth impact%)*(1-tax rate)/Market value ROE=9000*(1+0.2)*(1-0.35)/69000 ROE=10.17 %age change in ROE for Recession =(ROE recession/ROE normal-1)*100 =(0.0636/0.0848-1)*100 =-25% %age change in ROE for Growth =(ROE Growth/ROE normal-1)*100 =(0.1017/0.0848-1)*100 =19.93% f New market value = old market value-debt =69000-21900 =47100 ROE = (EBIT-debt*interest%)*(1-tax rate)/new market value Recession ROE = (EBIT*(1-recession impact%)-debt*interest %age)*(1-tax rate)/new market value ROE=(9000*(1-0.25)-21900*0.08)*(1-0.35)/47100 ROE=6.9 Normal ROE = (EBIT-debt*interest%)*(1-tax rate)/new market value ROE=(9000-21900*0.08)*(1-0.35)/47100 ROE=10 Expansion ROE= (EBIT*(1+growth impact%)-debt*interest %age)*(1-tax rate)/new market value ROE=(9000*(1+0.2)-21900*0.08)*(1-0.35)/47100 ROE=12.49 %age change in ROE for Recession =(ROE recession/ROE normal-1)*100 =(0.069/0.1-1)*100 =-31% %age change in ROE for Growth =(ROE Growth/ROE normal-1)*100 =(0.1249/0.1-1)*100 =24.9%