Question

Kaelea, Inc., has no debt outstanding and a total market value of $153,000. Earnings before interest and taxes, EBIT, are projected to be $9,500 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 30 percent lower. The company is considering a $45,300 debt issue with an interest rate of 5 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,100 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 %
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 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 %
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 %

Assume the firm has a tax rate of 35 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 %
Normal %
Expansion %

%?ROE
Recession %
Expansion %

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.)

ROE
Recession %
Normal %
Expansion %

%?ROE
Recession %
Expansion %

Hints

Answer 1

ROE= Net profit / Shareholders Equity

In this case, we are considering EBIT that is given

a) Find the table below . Please insert the ROE formula and calculate the respective ROEs

For calculating teh EBIT in expansion and recesssion :

EBIT - Expansion- 9500*1.2= 11400

EBIT- Recession - 9500*.7=6650

Including the three EBIT in ROE calculation

b) percentage difference

From the calculaton above, we can see that when the comapny is in depression- ROE decraeses by 2% and when it is expansing ROE increases by 1%

c) Recapitlaisation

We can straight away add 45300 in MV as it is going to be used to purchase shares and also MV?BV is 1 wich means that there is no difference in MV and BV

SO, New shareholders equity will be - $198300

for calculating the NP, we need to deduct the interest paid on debt

which is - 45300*5%- $2265

We need to arrive at new earnings to use our ROE formula

Substituing the new fgure in our excel we get the following

d)

ROE remianed same during expansion and decraesed by 1% during recession

e) assuming tax at 35%

We need to deduct tax also from earnings now,

NP= EBIT- Int- Taxes

ROE increased and decreased by 1% during expansion and recession

f) considering debt interest

percentage of change remained same during depression but increased by 1% during expasnion