Question

Kaelea, Inc., has no debt outstanding and a total market value of $82,000. Earnings before interest and taxes, EBIT, are projected to be $8,500 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 20 percent higher. If there is a recession, then EBIT will be 25 percent lower. The company is considering a $28,200 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 4,100 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	7.7 %
Normal	10.37 %
Expansion	12.44 %

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

	%?ROE
Recession	-25 %
Expansion	20 %

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.)

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.)

Assume the firm has a tax rate of 40 percent.

e. 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. (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	4.66 %
Normal	6.22 %
Expansion	7.46 %

%?ROE
Recession	-25 %
Expansion	20 %

f. Calculate return on equity, ROE, under each of the three economic scenarios after the recapitalization. Also, calculate the percentage changes in ROE for economic expansion and recession, assuming the firm goes through with the proposed recapitalization. (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.)

I was able to calculate some of the answers that I filled in above. They have already been varified by connect so I only need help with parts c,d, and f

Thanks.

Answer 1

c) Market to book ratio is 1, therefore market value equity = book value equity

Book value of equity post recapitalization = $82000 - $28200 = $53800

ROE in case of no Taxes

Particulars	Normal	Expansion	Recession
EBIT	$8500	$8500 + 20% = $10200	$8500 - 25% = $6375
Less: Interest on debt ($28200 x 7%)	$1974	$1974	$1974
Earnings before tax	$6526	$8226	$4401
Less: Taxes	0	0	0
Net Income (a)	$6526	$8226	$4401
Equity (b)	$53800	$53800	$53800
ROE [ (a / b) x 100 ]	12.13%	15.29%	8.18%

d) % change in ROE (Expansion) = [ (15.29% - 12.13%) / 12.13% ] x 100 = 26.05%

% change in ROE (Recession) = [ (8.18% - 12.13%) / 12.13% ] x 100 = (-)32.56%

f)

ROE in case of 40% tax

Particulars	Normal	Expansion	Recession
EBIT	$8500	$8500 + 20% = $10200	$8500 - 25% = $6375
Less: Interest on debt ($28200 x 7%)	$1974	$1974	$1974
Earnings before tax	$6526	$8226	$4401
Less: Taxes@40%	$2610.40	$3290.40	$1760.40
Net Income (a)	$3915.60	$4935.60	$2640.60
Equity (b)	$53800	$53800	$53800
ROE [ (a / b) x 100 ]	7.28%	9.17%	4.91%

d) % change in ROE (Expansion) = [ (9.17% - 7.28%) / 7.28% ] x 100 = 25.96%

% change in ROE (Recession) = [ (4.91% - 7.28%) / 7.28% ] x 100 = (-)32.55%