ROE and Leverage Suppose the firm in Problem 1 has a market-to-book ratio of 1.0. a....

ROE and Leverage Suppose the firm in Problem 1 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. 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 35 percent

Problem 1 is for reference in the question I need answered above

1.

EBIT and Leverage Castle, Inc., has no debt outstanding and a total market value of $305,000. Earnings before interest and taxes, EBIT, are projected to be $26,000 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 firm is considering a debt issue of $95,000 with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,000 shares outstanding. Ignore taxes for this problem.

Expert Solution

		Normal	Expansion	Recession
a)	EBIT	26000	31200	19500
	Total capital	305000	305000	305000
	Equity	305000	305000	305000
	Debt	0	0	0
	Interest	0	0	0
	EBT	26000	31200	19500
	Tax	0	0	0
	NI	26000	31200	19500
	ROE = NI/Equity [%)	8.52%	10.23%	6.39%
	% Change in ROE		20.00%	-25.00%
b)	EBIT	26000	31200	19500
	Total capital	305000	305000	305000
	Equity	210000	210000	210000
	Debt	95000	95000	95000
	Interest (95000*6%)	5700	5700	5700
	EBT	20300	25500	13800
	Tax	0	0	0
	NI	20300	25500	13800
	ROE = NI/Equity [%)	9.67%	12.14%	6.57%
	% Change in ROE		25.62%	-32.02%
c)	EBIT	26000	31200	19500
	Total capital	305000	305000	305000
	Equity	210000	210000	210000
	Debt	95000	95000	95000
	Interest (95000*6%)	5700	5700	5700
	EBT	20300	25500	13800
	Tax at 35%	7105	8925	4830
	NI	13195	16575	8970
	ROE = NI/Equity [%)	6.28%	7.89%	4.27%
	% Change in ROE		25.62%	-32.02%

jeff jeffy answered 2 years ago

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