Question

Kaelea, Inc., has no debt outstanding and a total market value of $90,000. Earnings before interest and taxes, EBIT, are projected to be $8,000 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 30 percent lower. The company is considering a $34,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 3,600 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.

b. Calculate the percentage changes in ROE when the economy expands or enters a recession, assuming no taxes.

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.

d. Calculate the percentage changes in ROE for economic expansion and recession.

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.

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.

Answer 1