Question

Kaelea, Inc., has no debt outstanding and a total market value of $130,000. Earnings before interest and taxes, EBIT, are projected to be $9,600 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 21 percent higher. If there is a recession, then EBIT will be 34 percent lower. The company is considering a $38,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,200 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.)

	ROE
Recession	%
Normal	%
Expansion	%

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 minussign. Do not round intermediate calculations and enter your answers as a percent rounded to the nearest whole number, e.g., 32.)

	%?ROE
Recession	%
Expansion	%

  
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.)

	ROE
Recession	%
Normal	%
Expansion	%

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.)

	%?ROE
Recession	%
Expansion	%

Answer 1

Current Market value	130,000
Current No of shares	5,200
Share price	25.00
Debt issue	38,000.00
Shares repurchased	1,520.00
Remaining shares	3,680.00
Before recapitalization
	Recession	Normal	Expansion
EBIT	6,336	9,600	11,616
Interest	-	-	-
EBT	6,336	9,600	11,616
Tax	-	-	-
EAT	6,336	9,600	11,616
Equity	130,000	130,000	130,000
Return on Equity	4.87%	7.38%	8.94%
Change in Return	-34.00%		21.00%
After recapitalization
	Recession	Normal	Expansion
EBIT	6,336	9,600	11,616
Interest- 38000*6%	(2,280)	(2,280)	(2,280)
EBT	4,056	7,320	9,336
Tax	-	-	-
EAT	4,056	7,320	9,336
Equity	92,000	92,000	92,000
Return on Equity	4.41%	7.96%	10.15%
Change in Return	-44.59%		27.54%