Question

Castle, 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. The firm is considering a debt issue of $95,000 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 stock price remains constant.

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. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to the nearest whole number, e.g., 32.)

  

% 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. (A negative answer 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. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to the nearest whole number, e.g., 32.)

% 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. (A negative answer 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 %

Answer 1

Before Debt Issue
		Normal Conditions	Expansion	Recession
	EBIT	36000	41400	27000
	Interest
	EBT	36000	41400	27000
	Taxes
		36000	41400	27000
	Shareholders Equity	150000	150000	150000
a-1	Return on Equity (Earnings after Taxes / Shareholders Equity)	24.00	27.60	18.00
a-2	% change in ROE		15.00	-25.00
After Debt Issue but without tax effect
		Normal Conditions	Expansion	Recession
	EBIT	36000	41400	27000
	Interest (95,000 * 8%)	7600	7600	7600
	EBT	28400	33800	19400
	Taxes
		28400	33800	19400
	Shareholders Equity	55000	55000	55000
b-1	Return on Equity (Earnings after Taxes / Shareholders Equity)	51.64	61.45	35.27
b-2	% change in ROE		19.01	-31.69
Before Debt Issue
		Normal Conditions	Expansion	Recession
	EBIT	36000	41400	27000
	Interest
	EBT	36000	41400	27000
	Taxes @ 35%	12600	14490	9450
		23400	26910	17550
	Shareholders Equity	150000	150000	150000
C-1	Return on Equity (Earnings after Taxes / Shareholders Equity)	15.60	17.94	11.70
c-2	% change in ROE		15.00	-25.00
After Debt Issue but without tax effect
		Normal Conditions	Expansion	Recession
	EBIT	36000	41400	27000
	Interest (95,000 * 8%)	7600	7600	7600
	EBT	28400	33800	19400
	Taxes @ 35%	9940	11830	6790
		18460	21970	12610
	Shareholders Equity	55000	55000	55000
C-3	Return on Equity (Earnings after Taxes / Shareholders Equity)	33.56	39.95	22.93
C-4	% change in ROE		19.01	-31.69