Question

Minion, Inc. has no debt outstanding and a total market value of $422,400. Earnings before interest and taxes, EBIT, are projected to be $55,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 14% higher. If there is a recession, then EBIT will be 20% lower. The company is considering a $205,000 debt issue with an interest rate of 6%. The proceeds will be used to repurchase shares of stock. There are currently 8,800 shares outstanding. Ignore taxes. Assume the company has a market-to-book ratio of 1.0 and the stock price remains constant.

a-1) calculate the return on equity, ROE, under each of the three economic scenarios before any debt is issued.

a-2) calculate the percentage changes in ROE when the economy expands or enters a recession.

b-1) assume the firm goes through the proposed recapitalization. calculate return on equity, ROE, under each of the three economic scenarios.

b-2) assume the firm goes through with the proposed recapitalization. calculate the percentage changes in ROE when the economy expands or enters a recession.

Answer 1