Pendergast, Inc., has no debt outstanding and a total market value of $180,000.
ID: 2731343 • Letter: P
Question
Pendergast, Inc., has no debt outstanding and a total market value of $180,000. Earnings before interest and taxes, EBIT, are projected to be $25,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 10 percent higher. If there is a recession, then EBIT will be 20 percent lower. Pendergast is considering a $60,000 debt issue with an interest rate of 5 percent. The proceeds will be used to repurchase shares of stock. There are currently 6,000 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))
a-1
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))
Explanation / Answer
Part a-1)
Amount of shareholders’ equity =180,000
ROE = Net Income/ Shareholders’ equity
ROE = (EBIT – Interest) x (1-t) / Shareholder’s equity
ROE in recession = ((25,000 x(1-0.20) -0) x (1-0)/ 180,000
= 20,000/ 180,000
= 11.11%
ROE in normal = (25,000 -0) x (1-0)/ 180,000
= 25,000 / 180,000
= 13.89%
ROE in expansion = ((25,000 x(1-0.10) -0) x (1-0)/ 180,000
= 27,500 / 180,000
= 15.28%
Part a-2)
% change in ROE = Change in ROE / ROE in normal
% change in ROE( Recession ) = (11.11%-13.89%)/13.89%
= -20.01%
% change in ROE (expansion) = (15.28%-13.89%)/13.89%
= 10.01%
Part a-2)
Since there in no tax rate, there will not be any tax benefit out of recapitalization.
Amount of shareholder’s equity = total value – debt
=180,000 -60,000
= 120,000
Annual interest expense = amount of debt x interest rate
= 60,000 x 5%
= 3,000
ROE = (EBIT – Interest) x (1-t) / Shareholder’s equity
ROE in recession = ((25,000 x(1-0.20) -3000) x (1-0)/ 120,000
= 17000/ 120,000
= 14.17%
ROE in normal = (25,000 -3000) x (1-0)/ 120,000
= 22,000 / 120,000
= 18.33%
ROE in expansion = ((25,000 x(1+0.10) -3000) x (1-0)/ 180,000
= 24500 / 120,000
= 20.42%
Part B2
% change in ROE = Change in ROE / ROE in normal
% change in ROE( Recession ) = (14.17%-18.33%)/18.33%
= -22.70%
% change in ROE (expansion) = (20.42%-18.33%)/18.33%
= 11.40%
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