Question

James Inc., has no debt outstanding and a total market value of $395,600. Earnings before interest and taxes, EBIT, are projected to be $53,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 13 percent higher. If there is a recession, then EBIT will be 22 percent lower. The company is considering a $195,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 8,600 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.

  

c-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.)
c-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.)
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 and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
c-4.	Given the 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

Market to book ratio = 1 so equity = 395,600

ROE = Net income/equity

EBIT in expansion = normal EBIT*(1+13%)

EBIT in recession = normal EBIT*(1-22%)

c-1).

State	EBIT	Equity	ROE
Expansion	59,890	395,600	15.14%
Normal	53,000	395,600	13.40%
Recession	41,340	395,600	10.45%

c-2). %age change in ROE when economy shifts from normal to expansion = (15.14%/13.40%)-1 = 13.00%

%age change in ROE when economy shifts from normal to recession = (10.45%/13.40%)-1 = -22.00%

c-3). If the recapitalization happens then equity equal to the debt amount issued will be bought back so new equity will be

old equity - debt = 395,600 - 195,000 = 200,600

Normal EBIT = EBIT - annual interest payment = 53,000 - (8%*195,000) = 37,400

EBIT in expansion = EBIT in expansion - annual interest payment = 59,890 - (8%*195,000) = 44,290

EBIT in recession = EBIT in recession - annual interest payment = 41,340 - (8%*195,000) = 25,740

State	EBIT	Equity	ROE
Expansion	44,290	200,600	22.08%
Normal	37,400	200,600	18.64%
Recession	25,740	200,600	12.83%

c-4). %age change in ROE when economy shifts from normal to expansion = (22.08%/18.64%)-1 = 18.42%

%age change in ROE when economy shifts from normal to recession = (12.83%/18.64%)-1 = -31.18%