Question

RAK, Inc., has no debt outstanding and a total market value of $250,000. Earnings before interest and taxes, EBIT, are projected to be $42,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 18 percent higher. If there is a recession, then EBIT will be 30 percent lower. RAK is considering a $100,000 debt issue with an interest rate of 8 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

1-
		Normal	Strong	Rcession
EBIT		42000	49560	29400
Less interest		0	0	0
EBT		42000	49560	29400
less taxes-0%		0	0	0
EAT		42000	49560	29400
total equity		250000	250000	250000
ROE	EAT/total of equtiy	16.80%	19.82%	11.76%
% change in ROE =(ROE in strong/recession - ROE at normal)/ ROE at normal			18.00%	-30.00%
2-
		Normal	Strong	Rcession
EBIT		42000	49560	29400
Less interest		8000	8000	8000
EBT		34000	41560	21400
less taxes-0%		0	0	0
EAT		34000	41560	21400
total equity		150000	150000	150000
ROE	EAT/total of equtiy	22.67%	27.71%	14.27%
% change in ROE =(ROE in strong/recession - ROE at normal)/ ROE at normal			22.24%	-37.06%
3-
		Normal	Strong	Rcession
EBIT		42000	49560	29400
Less interest		0	0	0
EBT		42000	49560	29400
less taxes-35%		14700	17346	10290
EAT		27300	32214	19110
total equity		250000	250000	250000
ROE	EAT/total of equtiy	10.92%	12.89%	7.64%
% change in ROE =(ROE in strong/recession - ROE at normal)/ ROE at normal			18.00%	-30.00%
4-
		Normal	Strong	Rcession
EBIT		42000	49560	29400
Less interest		8000	8000	8000
EBT		34000	41560	21400
less taxes-35%		11900	14546	7490
EAT		22100	27014	13910
total equity		150000	150000	150000
ROE	EAT/total of equtiy	14.73%	18.01%	9.27%
% change in ROE =(ROE in strong/recession - ROE at normal)/ ROE at normal			22.24%	-37.06%