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 $26,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 12 percent higher. If there is a recession, then EBIT will be 20 percent lower. RAK is considering a $90,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 10,000 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

Before Taxes
	Recession	Normal	Expansion
EBIT	20,800	26,000	29,120
Equity	150,000	150,000	150,000
ROE	13.87%	17.33%	19.41%
Change in ROE	(13.87%-17.33%)/17.33%		(19.41%-17.33%)/17.33%
Change in ROE	-20%		12.00%
	Recession	Normal	Expansion
EBIT	20,800	26,000	29,120
Less Interest-90000*6%	(5,400)	(5,400)	(5,400)
EBT	15,400	20,600	23,720
Equity	60,000	60,000	60,000
ROE	25.67%	34.33%	39.53%
Change in ROE	(25.67%-34.33%)/43.33%		(39.53%-34.33%)/43.33%
Change in ROE	-20%		12%
After Taxes
	Recession	Normal	Expansion
EBIT	20,800	26,000	29,120
Tax	(7,280)	(9,100)	(10,192)
EAT	13,520	16,900	18,928
Equity	150,000	150,000	150,000
ROE	9.01%	11.27%	12.62%
Change in ROE	(9.01%-11.27%)/11.27%		(12.62%-11.27%)/11.27%
Change in ROE	-20%		12%
	Recession	Normal	Expansion
EBIT	20,800	26,000	29,120
Less Interest-90000*6%	(5,400)	(5,400)	(5,400)
EBT	15,400	20,600	23,720
Less Taxes	(5,390)	(7,210)	(8,302)
EAT	10,010	13,390	15,418
Equity	60,000	60,000	60,000
ROE	16.68%	22.32%	25.70%
Change in ROE	(16.68%-22.32%)/22.32%		(25.70%-22.32%)/22.32%
Change in ROE	-25%		15%