Question

Kaelea, Inc., has no debt outstanding and a total market value of $125,000. Earnings before interest and taxes, EBIT, are projected to be $10,400 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 35 percent lower. Kaelea is considering a $42,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 6,250 shares outstanding. Assume Kaelea has a market-to-book ratio of 1.0.

Requirement 1:

(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. Enter your answers as a percentage 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. (Do not round intermediate calculations. Negative amounts should be indicated by a minus sign. Enter your answers as a percentage rounded to 2 decimal places (e.g., 32.16).) % Change in ROE Recession % Expansion % Requirement 2: Assume the firm goes through with the proposed recapitalization and no taxes. (a) Calculate return on equity, ROE, under each of the three economic scenarios after the recapitalization. (Do not round intermediate calculations. Round your answers to 2 decimal places (e.g., 32.16).) ROE Recession % Normal % Expansion % (b) Calculate the percentage changes in ROE for economic expansion and recession. (Do not roundintermediate calculations. Negative amounts should be indicated by a minus sign. Enter your answers as a percentage rounded to 2 decimal places (e.g., 32.16).) % Change in ROE Recession % Expansion % Requirement 3: Assume the firm has a tax rate of 35 percent. (a) 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. (Do not round intermediate calculations. Negative amounts should be indicated by a minus sign.Enter your answers as a percentage rounded to 2 decimal places (e.g., 32.16).) ROE Recession % Normal % Expansion % % Change in ROE Recession % Expansion % (b) 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. (Do not round intermediate calculations. Negative amounts should be indicated by a minus sign. Enter your answers as a percentage rounded to 2 decimal places (e.g., 32.16).) ROE Recession % Normal % Expansion % % Change in ROE Recession % Expansion %

Answer 1

	Requirement 1:
a)	Value of debt	0	0	0
	Value of equity	125000	125000	125000
	Total	125000	125000	125000
	Number of shares	6250	6250	6250
		Normal	Strong Expansion	Recession
	EBIT	10400	12480	6760
	Interest	0	0	0
	EBT	10400	12480	6760
	Tax = 0	0	0	0
	NI	10400	12480	6760
	ROE = (NI/Value of equity)	8.32%	9.98%	5.41%
b)	% Change in ROE		20.00%	-35.00%
	Requirement 2:
a)	Value of debt	42000	42000	42000
	Value of equity	83000	83000	83000
	Total	125000	125000	125000
	Number of shares (6250*83000/125000)	4150	4150	4150
		Normal	Strong Expansion	Recession
	EBIT	10400	12480	6760
	Interest = 42000*6% =	2520	2520	2520
	EBT	7880	9960	4240
	Tax= 0	0	0	0
	NI	7880	9960	4240
	ROE = (NI/Value of equity)	9.49%	12.00%	5.11%
b)	% Change in ROE		26.40%	-46.19%
	Requirement 3:
a)	Value of debt	0	0	0
	Value of equity	125000	125000	125000
	Total	125000	125000	125000
	Number of shares	6250	6250	6250
		Normal	Strong Expansion	Recession
	EBIT	10400	12480	6760
	Interest	0	0	0
	EBT	10400	12480	6760
	Tax at 35%	3640	4368	2366
	NI	6760	8112	4394
	ROE = (NI/Value of equity)	5.41%	6.49%	3.52%
	% Change in ROE		20.00%	-35.00%
b)	Value of debt	42000	42000	42000
	Value of equity	83000	83000	83000
	Total	125000	125000	125000
	Number of shares (6250*83000/125000)	4150	4150	4150
		Normal	Strong Expansion	Recession
	EBIT	10400	12480	6760
	Interest = 42000*6% =	2520	2520	2520
	EBT	7880	9960	4240
	Tax at 35%	2758	3486	1484
	NI	5122	6474	2756
	ROE = (NI/Value of equity)	6.17%	7.80%	3.32%
	% Change in ROE		26.40%	-46.19%