Question

            

Problem 1: EBIT and Leverage [LO1] Ghost, Inc., has no debt outstanding and a total market value of $185,000. Earnings before interest and taxes, EBIT, are projected to be $29,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 30 percent higher. If there is a recession, then EBIT will be 40 percent lower. The company is considering a $65,000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 7,400 shares outstanding. Ignore taxes for this problem.

Question: ROE and Leverage - Suppose the company in Problem 1 has a market-to-book ratio of 1.0 and the stock price remains constant.

a. Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. Also calculate the percentage changes in ROE for economic expansion and recession, assuming no taxes.                                                                                                                                                        

b. Repeat part (a) assuming the firm goes through with the proposed recapitalization.                                     

c. Repeat parts (a) and (b) of this problem assuming the firm has a tax rate of 21 percent.                             

Answer 1

		RECESSION	NORMAL	EXPANSION
a)	EBIT	17400	29000	37700
	EQUITY	185000	185000	185000
	ROE	0.0941	0.1568	0.2038
	SENSTIVITY ANALYSIS	NORMAL TO RECESSION
	% CHANGE IN ROE	-40%	=(0.0941-0.1568)/0.1568
	SENSTIVITY ANALYSIS	NORMAL TO EXPANSION
	% CHANGE IN ROE	30%	=(0.2038-0.1568)/0.1568
b)	NEW EQUITY = 185,000 - 65000	120000
	NET INCOME UNDER NORMAL	24450	=29000-(65000*7%)
		RECESSION	NORMAL	EXPANSION
	EBIT	12850	24450	33150
	EQUITY	120000	120000	120000
	ROE	0.1071	0.2038	0.2763
	SENSTIVITY ANALYSIS	NORMAL TO RECESSION
	% CHANGE IN ROE	-47.44%	=(0.1070-0.2038)/0.2038
	SENSTIVITY ANALYSIS	NORMAL TO EXPANSION
	% CHANGE IN ROE	35.58%	=(0.2763-0.2038)/0.2038
c)		RECESSION	NORMAL	EXPANSION
	EBIT	17400	29000	37700
	LESS: INTEREST	4550	4550	4550
	EBT	12850	24450	33150
	LESS:TAX AT 21%	2698.5	5134.5	6961.5
	NI	10151.5	19315.5	26188.5
	ROE	0.084595833	0.1609625	0.2182375
	SENSTIVITY ANALYSIS	NORMAL TO RECESSION
	% CHANGE IN ROE	-47.44%	=(0.0845-0.1609)/0.1609
	SENSTIVITY ANALYSIS	NORMAL TO EXPANSION
	% CHANGE IN ROE	35.58%	=(0.21823-0.1609)/0.1609

CHANGE IN ROE DOESNT CHANGE WITH TAX RATES IMPOSED