Question

RAK, Inc., has no debt outstanding and a total market value of $150,000. 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 15 percent higher. If there is a recession, then EBIT will be 25 percent lower. RAK is considering a $95,000 debt issue with an interest rate of 8 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 company has a market-to-book ratio of 1.0. 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. (Negative amounts 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 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. (Negative amounts 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. c-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 % c-2 Calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts 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 % 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. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) ROE Recession % Normal % Expansion % c-4 Given the recapitalization, calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places. (e.g., 32.16)) % change in ROE Recession % Expansion %

Answer 1

a-1

ROE = EBIT*(1-tax rate)/Market value

Recession

ROE = EBIT*(1-recession impact%)*(1-tax rate)/market value

ROE=36000*(1-0.25)*(1-0)/150000

ROE=18

Normal

ROE = EBIT*(1-tax rate)/Market value

ROE=36000*(1-0)/150000

ROE=24

Expansion

ROE = EBIT*(1+Growth impact%)*(1-tax rate)/Market value

ROE=36000*(1+0.15)*(1-0)/150000

ROE=27.6

a-2

%age change in ROE for Recession

=(ROE recession/ROE normal-1)*100

=(0.18/0.24-1)*100

=-25%

%age change in ROE for Growth

=(ROE Growth/ROE normal-1)*100

=(0.276/0.24-1)*100

=15%

b-1

New market value = old market value-debt

=150000-95000

=55000

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=(36000*(1-0.25)-95000*0.08)*(1-0)/55000

ROE=35.27

Normal

ROE = (EBIT-debt*interest%)*(1-tax rate)/new market value

ROE=(36000-95000*0.08)*(1-0)/55000

ROE=51.64

Expansion

ROE= (EBIT*(1+growth impact%)-debt*interest %age)*(1-tax rate)/new market value

ROE=(36000*(1+0.15)-95000*0.08)*(1-0)/55000

ROE=61.45

b-2

%age change in ROE for Recession

=(ROE recession/ROE normal-1)*100

=(0.3527/0.5164-1)*100

=-31.7%

%age change in ROE for Growth

=(ROE Growth/ROE normal-1)*100

=(0.6145/0.5164-1)*100

=19%

Please ask remaining parts seperately