Kaelea, Inc., has no debt outstanding and a total market value of $82,000. Earni
ID: 2720283 • Letter: K
Question
Kaelea, Inc., has no debt outstanding and a total market value of $82,000. Earnings before interest and taxes, EBIT, are projected to be $8,500 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 20 percent higher. If there is a recession, then EBIT will be 25 percent lower. Kaelea is considering a $28,200 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 4,100 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 before any debt is issued, assuming no taxes. (Do not round intermediate calculations. 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, assuming no taxes. (Do not round intermediate calculations. Negative amounts should be indicated by a minus sign.)
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).)
Calculate return on equity, 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. (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).)
Calculate return on equity, ROE, under each of the three economic scenarios after the recapitalization. Also, calculate the percentage changes in ROE for economic expansion and recession, assuming the firm goes through with the proposed recapitalization. (Do not round intermediate calculationsNegative 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 $82,000. Earnings before interest and taxes, EBIT, are projected to be $8,500 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 20 percent higher. If there is a recession, then EBIT will be 25 percent lower. Kaelea is considering a $28,200 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 4,100 shares outstanding. Assume Kaelea has a market-to-book ratio of 1.0.
Explanation / Answer
Requirement 1
a) ROE when no debt is issued and assuming no taxes
EBIT = $ 8500
Less:- Interest $0
EBT= $ 8500
Less:- Tax $0
Profit after Tax $ 8500
ROE= Profit after Tax/Shareholder's Equity
Profit after tax= $8500
Shareholders equity = $82000 since market to book ratio is 1.0
Therefore ROE is
Recession = $(8500*1.2)/$82000*100 = 12.44%
Normal= $8500/$82000*100 = 10.37%
Expansion= $(8500-(8500*.25))/$82000*100 = 7.77%
b) Percentage change in ROE
Expansion = Increase in PAT/Shareholder's Equity
$1700/$82000 = 2.07%
Recession = Decrease in PAT/Shareholder's Equity
$2125/$82000 = 2.59%
Requirement 2
a) ROE when debt is issued and assuming no taxes
EBIT = $ 8500
Less:- Interest $1974
EBT= $ 6526
Less:- Tax $0
Profit after Tax $ 6526 (Normal Case)
ROE= Profit after Tax/Shareholder's Equity
Profit after tax= $6526
Shareholders equity = $82000 - $28200 = $53800
Therefore ROE is
Recession = $(6526+1700)/$53800*100 = 15.29%
Normal= $6526/$53800*100 = 12.13%
Expansion= $(6526-2125))/$53800*100 = 8.18%
b) Percentage change in ROE
Expansion = Increase in PAT/Shareholder's Equity
$1700/$53800 = 3.16%
Recession = Decrease in PAT/Shareholder's Equity
$2125/$53800 = 3.95%
Requirement 3
a) ROE when no debt is issued and assuming taxe rate of 40%
EBIT = $ 8500
Less:- Interest $0
EBT= $ 8500
Less:- Tax $3400
Profit after Tax $ 5100
ROE= Profit after Tax/Shareholder's Equity
Profit after tax= $5100
Shareholders equity = $82000 since market to book ratio is 1.0
Therefore ROE is
Recession = $(5100+(1700*.6))/$82000*100 = 7.46%
Normal= $5100/$82000*100 = 6.22%
Expansion= $(5100-(2125*.6))/$82000*100 = 4.66%
Percentage change in ROE
Expansion = Increase in PAT/Shareholder's Equity
$(1700*.6)/$82000 = 1.24%
Recession = Decrease in PAT/Shareholder's Equity
$(2125*.6)/$82000 = 1.55%
b) ROE when debt is issued and assuming taxe rate of 40%
EBIT = $ 8500
Less:- Interest $1974
EBT= $ 6526
Less:- Tax $2610.40
Profit after Tax $ 3915.60
ROE= Profit after Tax/Shareholder's Equity
Profit after tax= $3915.60
Shareholders equity = $82000 -$28200 = $53800
Therefore ROE is
Recession = $(3915.60+(1700*.6))/$53800*100 = 9.17%
Normal= $3915.60/$53800*100 = 7.28%
Expansion= $(3915.60-(2125*.6))/$53800*100 = 4.91%
Percentage change in ROE
Expansion = Increase in PAT/Shareholder's Equity
$(1700*.6)/$82000 = 1.90%
Recession = Decrease in PAT/Shareholder's Equity
$(2125*.6)/$82000 = 2.37%
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