Question

Sunrise, Inc., has no debt outstanding and a total market value of $320,000. Earnings before interest and taxes, EBIT, are projected to be $47,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 19 percent higher. If there is a recession, then EBIT will be 30 percent lower. The company is considering a $165,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 8,000 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. a-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.) a-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.) b-1. Assume the firm goes through with the proposed recapitalization. Calculate the return on equity (ROE) under each of the three economic scenarios. (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) 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

Normal:

EBIT = $47,000

Recession:

EBIT = $47,000 - 30% * $47,000
EBIT = $32,900

Expansion:

EBIT = $47,000 + 19% * $47,000
EBIT = $55,930

Answer a-1.

Total Value = $320,000
Number of shares outstanding = 8,000

Price per share = Total Value / Number of shares outstanding
Price per share = $320,000 / 8,000
Price per share = $40.00

Answer a-2.

If economy expand:

Percentage Change in EPS = ($6.99 - $5.88) / $5.88
Percentage Change in EPS = 18.88%

If economy collapse:

Percentage Change in EPS = ($4.11 - $5.88) / $5.88
Percentage Change in EPS = -30.10%

Answer b-1.

Value of Debt = $165,000

Interest Expense = 6% * $165,000
Interest Expense = $9,900

Value of Equity = $155,000
Price per share = $40.00

Number of shares outstanding = $155,000 / $40.00
Number of shares outstanding = 3,875

Answer b-2.

If economy expand:

Percentage Change in EPS = ($11.88 - $9.57) / $9.57
Percentage Change in EPS = 24.14%

If economy collapse:

Percentage Change in EPS = ($5.94 - $9.57) / $9.57
Percentage Change in EPS = -37.93%