Question

1. Control Inc., has no debt outstanding and a total market value of $100,000. EBIT is projected to be $6,000 if economic conditions are normal. If there is a strong expansion in the economy, then EBIT will be 30% higher. If there is a recession, then EBIT will be 60% lower. The firm is considering a $40,000 debt issue with 5% interest rate. The proceeds will be used to repurchase shares of stock. There are currently 2,500 shares outstanding. Ignore taxes for this problem.

Suppose the firm in problem 1 has a market-to-book ratio of 1 (i.e., MV= TE= $100,000).

a- Calculate 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, assuming no taxes. (2.4%; 6%; 7.8%; -60%; 30%)

b- Repeat part (a) assuming the firm goes through with the proposed capitalization. (0.67%; 6.67%; 9.67%; -90%, 45%) c- Repeat parts (a) and (b) of this problem assuming the firm has a tax rate of 35%. (No debt: 1.56%; 3.9%; 5.07%; -60%, 30%; with debt: 0.43%; 4.33%; 6.28%; -90%, 45%)

no excel, please show formulas. I will rate

Answer 1

	1-	Without proposed restructuring
	Economic condition		Normal		strong expansion		recession
	EBIT		6000	6000*1.3	7800	6000*(1-0.6)	2400
	less interest		0		0		0
	before tax profit		6000		7800		2400
	less tax-0%		0		0		0
	after tax profit		6000		7800		2400
	no of shares		2500		2500		2500
	EPS = after tax profit/no of shares	6000/2500	2.4	7800/2500	3.12	2400/2500	0.96
	% change in EPS = (EPS in expansion or recession - EPS in normal)/EPS in nornal			(3.12-2.4)/2.4	30.00%	(0.96-2.4)/2.4	-60%
	2-
With proposed capital restructuring	Economic condition		Normal		strong expansion		recession
	EBIT		6000	6000*1.3	7800	6000*(1-0.6)	2400
	less interest	40000*5%	2000		2000		2000
	before tax profit		4000		5800		400
	less tax-0%		0		0		0
	after tax profit		4000		5800		400
	no of shares		1500		1500		1500
	EPS = after tax profit/no of shares	4000/1500	2.67	5800/1500	3.87	400/1500	0.27
	% change in EPS = (EPS in expansion or recession - EPS in normal)/EPS in nornal			(3.87-2.67)/2.67	45%	(.27-2.67)/2.67	-90%
	Market value per share	total market value/no of shares issued	100000/2500	40
	shares purchased from debt proceeds	total amount of dent/market price per share	40000/40	1000
	shares remaining after repurchase	2500-1000	1500
	3-1
without proposed capital structure but with tax rate of 35%	Economic condition		Normal		strong expansion		recession
	EBIT		6000	6000*1.3	7800	6000*(1-0.6)	2400
	less interest		0		0		0
	before tax profit		6000		7800		2400
	less tax-35%	6000*35%	2100	7800*35%	2730	2400*35%	840
	after tax profit		3900		5070		1560
	no of shares		2500		2500		2500
	EPS = after tax profit/no of shares	3900/2500	1.56	5070/2500	2.028	1560/2500	0.624
	% change in EPS = (EPS in expansion or recession - EPS in normal)/EPS in nornal			(2.028-1.56)/1.56	30%	(.624-1.56)/1.56	-60%
	1
With proposed capital restructuring and tax rate of 35%	Economic condition		Normal		strong expansion		recession
	EBIT		6000	6000*1.3	7800	6000*(1-0.6)	2400
	less interest	40000*5%	2000		2000		2000
	before tax profit		4000		5800		400
	less tax-35%		1400		2030		140
	after tax profit		2600		3770		260
	no of shares		1500		1500		1500
	EPS = after tax profit/no of shares	2600/1500	1.73	3770/1500	2.51	260/1700	0.17
	% change in EPS = (EPS in expansion or recession - EPS in normal)/EPS in normal			(2.51-1.73)/1.73	45%	(0.17-1.73)/1.73	-90%
	Market value per share	total market value/no of shares issued	100000/2500	40
	shares purchased from debt proceeds	total amount of dent/market price per share	40000/40	1000
	shares remaining after repurchase	2500-1000	1500