Question

RAK, Inc., has no debt outstanding and a total market value of $140,000. Earnings before interest and taxes, EBIT, are projected to be $32,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 12 percent higher. If there is a recession, then EBIT will be 30 percent lower. RAK is considering a $115,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 7,000 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

a-1)	Value of debt	0	0	0
	Value of equity	140000	140000	140000
	Total	140000	140000	140000
	Number of shares	7000	7000	7000
		Normal	Strong Expansion	Recession
	EBIT	32000	35840	22400
	Interest	0	0	0
	EBT	32000	35840	22400
	Tax = 0	0	0	0
	NI	32000	35840	22400
	ROE = (NI/Value of equity)	22.86%	25.60%	16.00%
a-2)	% Change in ROE		12.00%	-30.00%
b-1)	Value of debt	115000	115000	115000
	Value of equity	25000	25000	25000
	Total	140000	140000	140000
	Number of shares (7000*25000/140000)	1250	1250	1250
		Normal	Strong Expansion	Recession
	EBIT	32000	35840	22400
	Interest = 115000*6% =	6900	6900	6900
	EBT	25100	28940	15500
	Tax= 0	0	0	0
	NI	25100	28940	15500
	ROE = (NI/Value of equity)	100.40%	115.76%	62.00%
b-2)	% Change in ROE		15.30%	-38.25%
c-1)	Value of debt	0	0	0
	Value of equity	140000	140000	140000
	Total	140000	140000	140000
	Number of shares	7000	7000	7000
		Normal	Strong Expansion	Recession
	EBIT	32000	35840	22400
	Interest	0	0	0
	EBT	32000	35840	22400
	Tax at 35%	11200	12544	7840
	NI	20800	23296	14560
	ROE = (NI/Value of equity)	14.86%	16.64%	10.40%
c-2)	% Change in ROE		12.00%	-30.00%
c-3)	Value of debt	115000	115000	115000
	Value of equity	25000	25000	25000
	Total	140000	140000	140000
	Number of shares (7000*25000/140000)	1250	1250	1250
		Normal	Strong Expansion	Recession
	EBIT	32000	35840	22400
	Interest = 115000*6% =	6900	6900	6900
	EBT	25100	28940	15500
	Tax at 35%	8785	10129	5425
	NI	16315	18811	10075
	ROE = (NI/Value of equity)	65.26%	75.24%	40.30%
c-4)	% Change in ROE		15.30%	-38.25%