RAK, Inc., has no debt outstanding and a total market value of $200,000. Earning
ID: 2711703 • Letter: R
Question
RAK, Inc., has no debt outstanding and a total market value of $200,000. Earnings before interest and taxes, EBIT, are projected to be $24,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 15 percent higher. If there is a recession, then EBIT will be 30 percent lower. RAK is considering a $70,000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 8,000 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. (Do not round intermediate calculations. Enter your answers as a percent rounded 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. Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
Calculate the return on equity (ROE) under each of the three economic scenarios. (Do not round intermediate calculations. Enter your answers as a percent rounded 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. Do not round intermediate calculations. Enter your answers as a percent rounded 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. (Do not round intermediate calculations. Enter your answers as a percent rounded 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. Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
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. Enter your answers as a percent rounded 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))
RAK, Inc., has no debt outstanding and a total market value of $200,000. Earnings before interest and taxes, EBIT, are projected to be $24,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 15 percent higher. If there is a recession, then EBIT will be 30 percent lower. RAK is considering a $70,000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 8,000 shares outstanding. Ignore taxes for questions a and b. Assume the company has a market-to-book ratio of 1.0.
Explanation / Answer
a.1 Since the company has a market-to-book ratio of 1.0, the total equity of the firm is equal to the market value of equity. Using the equation for ROE:
ROE = NI/$200,000
The ROE for each state of the economy under the current capital structure and no taxes is:
Recession
Normal
Expansion
ROE
.084
.12
.138
a.2)
Recession
Normal
Expansion
ROE
.084
.12
.138
%DROE
–30
–––
+15
The second row shows the percentage change in ROE from the normal economy.
B.1&B2.If the company undertakes the proposed recapitalization, the new equity value will be:
Equity = $200,000 – 70,000
Equity = $130,000
So, the ROE for each state of the economy is:
ROE = NI/$130,000
Recession
normal
expansion
EBIT
16800
24,000
27600
Interest
3000
3000
3000
NI (EBIT-Interest)
13800
21000
24600
ROE
0.106154
0.161538
0.189230769
%Change ROE
-34.29%
-----------
17.14%
C1&c2 :If there are corporate taxes and the company maintains its current capital structure, the ROE is:
Recession
normal
expansion
EBIT
16800
24,000
27600
Taxes
10920
15600
17940
NI (EBIT-Taxes
16800
24000
27600
ROE
0.084
0.12
0.138
%Change ROE
-30.00%
-----------
15.00%
Notice that the percentage change in ROE is the same as the percentage change in EPS. The percentage change in ROE is also the same with or without taxes.
C3 & C4)With Recapitalisation:
Recession
normal
expansion
EBIT
16800
24,000
27600
Interest
3000
3000
3000
EBT
13800
21000
24600
Taxes
8970
13650
15990
NI (EBIT-Interest)
13800
21000
24600
ROE
0.11
0.16
0.12
%Change ROE
-34.29%
-----------
17.14%
Recession
Normal
Expansion
ROE
.084
.12
.138
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.