Beckett, Inc., has no debt outstanding and a total market value of $180,000. Ear
ID: 2739819 • Letter: B
Question
Beckett, 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. Beckett 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. a-1. Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. a-2.Calculate the percentage changes in ROE when the economy expands or enters a recession. **Assume the firm goes through with the proposed recapitalization.(for questions b-1 and b-2).** b-1. Calculate the return on equity (ROE) under each of the three economic scenarios. b-2. Calculate the percentage changes in ROE when the economy expands or enters a recession. **Assume the firm has a tax rate of 35 percent.(c-1,c-2,c-3,c-4)** c-1. Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. c-2. Calculate the percentage changes in ROE when the economy expands or enters a recession. c-3. Calculate the return on equity (ROE) under each of the three economic scenarios assuming the firm goes through with the recapitalization. c-4. Given the recapitalization, calculate the percentage changes in ROE when the economy expands or enters a recession
Explanation / Answer
a-1 and a-2.
Market to book ratio = 1
Hence book value of equity is equal to market value of equity i.e. $180,000.
Return on equity = Net income / Equity
In absence of debt and taxes, net income is equal to Earnings before interest and taxes (EBIT) i.e. $25,000
State of economy
Normal condition
Strong expansion
Recession
Net income
$ 25,000
$ 27,500
$ 20,000
Book value of equity
$ 180,000
$ 180,000
$ 180,000
ROE = Net income / Equity
0.1389
0.1528
0.1111
Change in ROE
0.0139
-0.0278
Percentage change in ROE
10.00%
-20.00%
b-1 and b-2.
Amount of debt issued = $60,000
Value of equity after recapitalisation = Value of equity – Debt issued = $180,000 - $60,000 = $120,000
State of economy
Normal condition
Strong expansion
Recession
EBIT
$ 25,000
$ 27,500
$ 20,000
Less: Interest on debt ($60,000*5%)
$ 3,000
$ 3,000
$ 3,000
Net income
$ 22,000
$ 24,500
$ 17,000
Book value of equity
$ 120,000
$ 120,000
$ 120,000
ROE = Net income / Equity
0.1833
0.2042
0.1417
Change in ROE
0.0208
-0.0417
Percentage change in ROE
11.36%
-22.73%
c-1 and c-2
State of economy
Normal condition
Strong expansion
Recession
EBT
$ 25,000
$ 27,500
$ 20,000
Less: Taxes at 35%
$ 8,750
$ 9,625
$ 7,000
Net income
$ 16,250
$ 17,875
$ 13,000
Book value of equity
$ 180,000
$ 180,000
$ 180,000
ROE = Net income / Equity
0.0903
0.0993
0.0722
Change in ROE
0.0090
-0.0181
Pecentage change in ROE
10.00%
-20.00%
c-3 and c-4.
State of economy
Normal condition
Strong expansion
Recession
EBIT
$ 25,000
$ 27,500
$ 20,000
Less: Interest on debt ($60,000*5%)
$ 3,000
$ 3,000
$ 3,000
EBT
$ 22,000
$ 24,500
$ 17,000
Less: Taxes at 35%
$ 7,700
$ 8,575
$ 5,950
Net income
$ 14,300
$ 15,925
$ 11,050
Book value of equity
$ 180,000
$ 180,000
$ 180,000
ROE = Net income / Equity
0.0794
0.0885
0.0614
Change in ROE
0.0090
-0.0181
Percentage change in ROE
11.36%
-22.73%
State of economy
Normal condition
Strong expansion
Recession
Net income
$ 25,000
$ 27,500
$ 20,000
Book value of equity
$ 180,000
$ 180,000
$ 180,000
ROE = Net income / Equity
0.1389
0.1528
0.1111
Change in ROE
0.0139
-0.0278
Percentage change in ROE
10.00%
-20.00%
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