Question

Kaelea, Inc., has no debt outstanding and a total market value of $165,000. Earnings before interest and taxes, EBIT, are projected to be $9,900 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 24 percent higher. If there is a recession, then EBIT will be 31 percent lower. The company is considering a $46,500 debt issue with an interest rate of 5 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,500 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.)

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.)

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.)

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.)

Assume the firm has a tax rate of 40 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.)
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.)

Answer 1

a]	NO DEBT AND NO TAXES:	Normal [100%]	Strong Expansion [124%]	Recession [69%]
	Debt	$                   -	$                     -	$                  -
	Equity	$       165,000	$         165,000	$       165,000
	Total capital	$       165,000	$         165,000	$       165,000
	EBIT	$            9,900	$           12,276	$           6,831
	Interest	$                   -	$                     -	$                  -
	EBT	$            9,900	$           12,276	$           6,831
	Tax at 0%	$                   -	$                     -	$                  -
	NI	$            9,900	$           12,276	$           6,831
	ROE [NI/Equity]	6.00%	7.44%	4.14%
b]	% Change		24.00%	-31.00%
c]	WITH DEBT AND NO TAXES:	Normal [100%]	Strong Expansion [124%]	Recession [69%]
	Debt	$ 46,500	$ 46,500	$         46,500
	Equity	$ 118,500	$ 118,500	$       118,500
	Total capital	$ 165,000	$ 165,000	$       165,000
	EBIT	$            9,900	$ 12,276	$           6,831
	Interest at 5%	$            2,325	$              2,325	$           2,325
	EBT	$            7,575	$              9,951	$           4,506
	Tax at 0%	$                   -	$                     -	$                  -
	NI	$            7,575	$              9,951	$           4,506
	ROE [NI/Equity]	6.39%	8.40%	3.80%
d]	% Change		31.37%	-40.51%
e]	NO DEBT AND WITH TAXES:	Normal [100%]	Strong Expansion [124%]	Recession [69%]
	Debt	$                   -	$                     -	$                  -
	Equity	$       165,000	$         165,000	$       165,000
	Total capital	$       165,000	$         165,000	$       165,000
	EBIT	$            9,900	$           12,276	$           6,831
	Interest	$                   -	$                     -	$                  -
	EBT	$            9,900	$           12,276	$           6,831
	Tax at 40%	$            3,960	$              4,910	$           2,732
	NI	$            5,940	$              7,366	$           4,099
	ROE [NI/Equity]	3.60%	4.46%	2.48%
	% Change		24.00%	-31.00%
f]	WITH DEBT AND WITH TAXES:	Normal [100%]	Strong Expansion [124%]	Recession [69%]
	Debt	$ 46,500	$ 46,500	$         46,500
	Equity	$ 118,500	$ 118,500	$       118,500
	Total capital	$ 165,000	$ 165,000	$       165,000
	EBIT	$            9,900	$ 12,276	$           6,831
	Interest at 5%	$            2,325	$              2,325	$           2,325
	EBT	$            7,575	$              9,951	$           4,506
	Tax at 40%	$            3,030	$              3,980	$           1,802
	NI	$            4,545	$              5,971	$           2,704
	ROE [NI/Equity]	3.84%	5.04%	2.28%
	% Change		31.37%	-40.51%