Question

Ghost, Inc., has no debt outstanding and a total market value of $382,500. Earnings before interest and taxes, EBIT, are projected to be $52,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 14 percent higher. If there is a recession, then EBIT will be 23 percent lower. The company is considering a $190,000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 8,500 shares outstanding. Ignore taxes for questions a and b. Assume the company has a market-to-book ratio of 1.0 and the stock price remains constant.

-1.	Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
c-2.	Calculate the percentage changes in ROE when the economy expands or enters a 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.)
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 and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
c-4.	Given the recapitalization, calculate the percentage changes in ROE when the economy expands or enters a 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.)

Answer 1

Answer 1:

Scenario 1 - Normal Condition

EBIT = $52000, Market cap = $382,500

As there is no debt, Market cap = Total equity

ROE = Net income / Equity

Now, there is no debt, hence interest = 0 and taxes are to be ignored as given in the problem

Hence, Net income = EBIT

ROE = EBIT / Market cap

= 52000 / 382500

Hence, ROE = 13.59%

Scenario 2 - Expansion in economy

EBIT will increase by 14%

So, EBIT = 1.14 * $52000 = $59280

ROE = 59280 / 382500

Hence, ROE = 15.49%

Scenario 3 - Depression in economy

EBIT will decrease by 23%

So, EBIT = 0.77 * $52000 = $40040

ROE = 40040 / 382500

Hence, ROE = 10.46%

Answer 2:

Change in ROE in expansion = (15.49 - 13.59) / 13.59 * 100 = +13.98%

Change in ROE in depression = (10.46 - 13.59) / 13.59 *100 = -23.03%

Answer 3:

Company is considering $190000 debt with 7% interest

Hence, interest = 0.07 * $190000 = $13300

Net income = EBIT - interest - taxes = $52000 - $13300 = $38700

Equity = Market cap - debt = $382,500 - $190,000 = $192,500

Scenario 1 - Normal condition

ROE = Net income / Equity

= 38700 / 192500

Hence, ROE = 20.10%

Scenario 2 - Expansion in economy

EBIT = $59280

Net income = EBIT - interest - taxes = $59280 - $13300 = $45980

ROE = 45980 / 192500

Hence, ROE = 23.88%

Scenario 3 - Depression in economy

EBIT = $40040

Net income = EBIT - interest - taxes = $40040 - $13300 = $26740

ROE = 26740 / 192500

Hence, ROE = 13.89%

Answer 4:

Change in ROE in expansion = (23.88 - 20.10) / 20.10 * 100 = +18.80%

Change in ROE in depression = (13.89 - 20.10) / 20.10 *100 = -30.89%