Question

Castle, Inc., has no debt outstanding and a total market value of $180,000. Earnings before interest and taxes, EBIT, are projected to be $25,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 10 percent higher. If there is a recession, then EBIT will be 20 percent lower. The firm is considering a debt issue of $60,000 with an interest rate of 5 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.

a-2. Calculate the percentage changes in ROE when the economy expands or enters a recession.

Assume the firm goes through with the proposed recapitalization b-1. Calculate the return on equity (ROE) under each of the three economic scenarios.

b-2. Calculate the percentage changes in ROE when the economy expands or enters a recession.

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.

c-2. Calculate the percentage changes in ROE when the economy expands or enters a recession.

c-3. Calculate the return on equity (ROE) under each of the three economic scenarios assuming the firm goes through with the recapitalization.

c-4. Given the recapitalization, calculate the percentage changes in ROE when the economy expands or enters a recession.

Answer 1