Question

Sunrise, Inc., has no debt outstanding and a total market value of $284,900. Earnings before interest and taxes, EBIT, are projected to be $44,000 if economic conditions are normal. If there is a strong expansion in the economy, then EBIT will be 18 percent higher. If there is a recession, then EBIT will be 29 percent lower. The company is considering a $150,000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 7,700 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.

Assume the firm has a tax rate of 22 percent.

c-1.	Calculate the 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

c-1

ROE = EBIT*(1-tax rate)/Market value

Recession

ROE = EBIT*(1-recession impact%)*(1-tax rate)/market value

ROE=44000*(1-0.29)*(1-0.22)/284900

ROE=8.55

Normal

ROE = EBIT*(1-tax rate)/Market value

ROE=44000*(1-0.22)/284900

ROE=12.05

Expansion

ROE = EBIT*(1+Growth impact%)*(1-tax rate)/Market value

ROE=44000*(1+0.18)*(1-0.22)/284900

ROE=14.21

c-2

%age change in ROE for Recession

=(ROE recession/ROE normal-1)*100

=(0.0855/0.1205-1)*100

=-29%

%age change in ROE for Growth

=(ROE Growth/ROE normal-1)*100

=(0.1421/0.1205-1)*100

=17.93%

c-3

New market value = old market value-debt

=284900-150000

=134900

ROE = (EBIT-debt*interest%)*(1-tax rate)/new market value

Recession

ROE = (EBIT*(1-recession impact%)-debt*interest %age)*(1-tax rate)/new market value

ROE=(44000*(1-0.29)-150000*0.07)*(1-0.22)/134900

ROE=11.99

Normal

ROE = (EBIT-debt*interest%)*(1-tax rate)/new market value

ROE=(44000-150000*0.07)*(1-0.22)/134900

ROE=19.37

Expansion

ROE= (EBIT*(1+growth impact%)-debt*interest %age)*(1-tax rate)/new market value

ROE=(44000*(1+0.18)-150000*0.07)*(1-0.22)/134900

ROE=23.95

c-4

%age change in ROE for Recession

=(ROE recession/ROE normal-1)*100

=(0.1199/0.1937-1)*100

=-38.1%

%age change in ROE for Growth

=(ROE Growth/ROE normal-1)*100

=(0.2395/0.1937-1)*100

=23.64%