Pendergast, Inc., has no debt outstanding and a total market value of $220,000.
ID: 2648939 • Letter: P
Question
Pendergast, Inc., has no debt outstanding and a total market value of $220,000. Earnings before interest and taxes, EBIT, are projected to be $36,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 18 percent higher. If there is a recession, then EBIT will be 25 percent lower. Pendergast is considering a $125,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 11,000 shares outstanding. Ignore taxes for questions a and b. Assume the company has a market-to-book ratio of 1.0.
Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Round your answers to 2 decimal places. (e.g., 32.16))
Calculate the percentage changes in ROE when the economy expands or enters a recession.(Negative amounts should be indicated by a minus sign.)
Calculate the return on equity (ROE) under each of the three economic scenarios. (Round your answers to 2 decimal places. (e.g., 32.16))
Calculate the percentage changes in ROE when the economy expands or enters a recession.(Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places. (e.g., 32.16))
Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Round your answers to 2 decimal places. (e.g., 32.16))
Calculate the percentage changes in ROE when the economy expands or enters a recession.(Negative amounts should be indicated by a minus sign.)
Calculate the return on equity (ROE) under each of the three economic scenarios assuming the firm goes through with the recapitalization. (Round your answers to 2 decimal places. (e.g., 32.16))
Given the recapitalization, calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places. (e.g., 32.16))
Pendergast, Inc., has no debt outstanding and a total market value of $220,000. Earnings before interest and taxes, EBIT, are projected to be $36,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 18 percent higher. If there is a recession, then EBIT will be 25 percent lower. Pendergast is considering a $125,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 11,000 shares outstanding. Ignore taxes for questions a and b. Assume the company has a market-to-book ratio of 1.0.
Explanation / Answer
Answer: a-1 Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued:
Since the firm has a market to book value of 1.0, the total equity of the firm is equal to the market value of equity.
ROE = NI/E = NI/$220,000
The ROE for each state of the economy under the current capital structure and no taxes is:
Answer a-2
Sensitivity Analysis: Normal to Recession
%?ROE = (0.1227-0.1636)/0.1636 =-25%
Sensitivity Analysis: Normal to Expansion
%?ROE = (0.1931-0.1636)/0.1636 =18.03%
Answer:b-1
Repeat part (a) assuming the firm goes through with the recapitalization.
Assuming no taxes, interest on debt of 8%.
If the firm goes forward with recapitalization, the new equity value will be:
Equity = $220,000-$125,000 or $95,000 [due to reduction of shares outstanding]
So, the ROE for each state of the economy is:
ROE = NI/$95,000
Answer:b-2
Sensitivity Analysis: Normal to Recession
%?ROE = (0.1789-0.2736)/0.2736 =-34.61%
Sensitivity Analysis: Normal to Expansion
%?ROE = (0.3419-0.2736)/0.2736 =24.96%
Answer:c-1
Repeat parts (a) and (b) of this problem considering the fact that the Company has a 35% tax rate.
Answer:c-2
Sensitivity Analysis: Normal to Recession
%?ROE = (0.08-0.1064)/0.1064 =-24.81%
Sensitivity Analysis: Normal to Expansion
%?ROE = (0.1255-0.1064)/0.1064 =17.95%
Answer:c-3
Answer:c-4
Sensitivity Analysis: Normal to Recession
%?ROE = (0.1163-0.1779)/0.1779 =-34.63%
Sensitivity Analysis: Normal to Expansion
%?ROE = (0.2222-0.1779)/0.1779 =24.90%
Recession Normal Expansion ROE $27000/$220000 $36000/$220000 $42480/$220000 ROE 0.1227 0.1636 0.1931 25% lower 18% higherRelated Questions
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