Kaelea, Inc., has no debt outstanding and a total market value of $100,000. Earn
ID: 2645987 • Letter: K
Question
Kaelea, Inc., has no debt outstanding and a total market value of $100,000. Earnings before interest and taxes, EBIT, are projected to be $8,400 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 24 percent higher. If there is a recession, then EBIT will be 31 percent lower. Kaelea is considering a $35,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 4,000 shares outstanding. Assume Kaelea has a market-to-book ratio of 1.0.
Calculate return on equity, ROE, under each of the three economic scenarios after the recapitalization. (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).)
Calculate the percentage changes in ROE for economic expansion and recession. (Do not round intermediate calculations. Negative amounts should be indicated by a minus sign. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).)
Kaelea, Inc., has no debt outstanding and a total market value of $100,000. Earnings before interest and taxes, EBIT, are projected to be $8,400 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 24 percent higher. If there is a recession, then EBIT will be 31 percent lower. Kaelea is considering a $35,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 4,000 shares outstanding. Assume Kaelea has a market-to-book ratio of 1.0.
Explanation / Answer
Part a)
If the proposed recapitalization is undertaken, the value of equity will change to $65,000 ($100,000 - $35,000), that is, it will get reduced by the value of debt. The formula for calculating return on equity is:
Return on Equity = Net Income/Equity*100.
Net Income Under Recession = EBIT*(1-Decline %)
Net Income Under Normal Conditions = EBIT
Net Income Under Expansion = EBIT*(1+Growth %)
EBIT under each scenario will be adjusted for the amount of interest on the debt which is $2,100 ($35,000*6%) to get the net income.
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Using the information provided in the question, we get,
ROE (Recession) = (8,400*(1-31%) - 2,100)/65,000*100 = 5.69%
ROE (Normal) = (8,400-2,100)/65,000*100 = 9.69%
ROE (Expansion) = (8,400*(1+24%) - 2,100)/65,000*100 = 12.79%
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Part b)
The formula for calculating % change in ROE from Normal to Expansion is:
% Change in ROE = (ROE Under Expansion - ROE Under Normal Conditions)/ROE Under Normal Conditions*100
The formula for calculating % change in ROE from Normal to Recession is:
% Change in ROE = (ROE Under Recession - ROE Under Normal Conditions)/ROE Under Normal Conditions*100
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Using the values calculated in part a), we get,
% Change in ROE (Recession) = (5.69% - 9.69%)/5.69%*100 = -41.33%
% Change in ROE (Expansion) = (12.79% - 9.69%)/9.69%*100 = 31.99% or 32%
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