1. KL Inc., has no debt outstanding and a total market value of $70,000. Earning

Question

1. KL Inc., has no debt outstanding and a total market value of $70,000. Earnings before interest and taxes, EBIT, are projected to be $6,000 if economic conditions are normal. If there is a strong expansion in the economy, then EBIT will be 25 percent higher. If there is a recession, tehn EBIT will be 40 percent lower. KL is considering a $35,000 debt issue with 6% annual interest rate. The proceeds will be used to repurchase shares of stock. There are currently 3,500 shares outstanding. The current KL

Explanation / Answer

a) Normal Eco Conditions EPS = $6000*(1-.35)/3500 = $1.114 ROE = $6000*(1-.35)/$70000 = 0.05571 strong expansion EPS = $6000*(1-.35)/3500 * 1.25= $1.393 ROE = $6000*(1-.35)/$70000 * 1.25 = 0.06964 recession EPS = $6000*(1-.35)/3500 * 0.6= $0.6686 ROE = $6000*(1-.35)/$70000 * 0.6 = 0.0334 If the debt is used to repurchase shares total outstanding equity = $70000-$35000 = $35000 total outstanding shares = 35000/70000*3500 = 1750 To make the EPS and ROE indifferent, EBIT required = $6000*70000/35000= $12000

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