Kaelea, Inc., has no debt outstanding and a total market value of $90,000. Earni
ID: 2751255 • Letter: K
Question
Kaelea, Inc., has no debt outstanding and a total market value of $90,000. Earnings before interest and taxes, EBIT, are projected to be $8,000 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 30 percent lower. Kaelea is considering a $34,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 3,600 shares outstanding. Assume Kaelea has a market-to-book ratio of 1.0. Requirement 1: (a) 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).) ROE Recession % Normal % Expansion % (b) 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.) %ROE Recession -30 % Expansion 20 % Requirement 2: Assume the firm goes through with the proposed recapitalization and no taxes. (a) 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).) ROE Recession % Normal % Expansion % (b) 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).) %ROE Recession % Expansion % Requirement 3: Assume the firm has a tax rate of 35 percent. (a) 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).) ROE Recession % Normal % Expansion % %ROE Recession % Expansion % (b) 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 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).) ROE Recession % Normal % Expansion % %ROE Recession % Expansion %
Explanation / Answer
Kaelea INC. Details Amt $ Market to Book Value 1 Market value 90,000 Book Value of Equity 90,000 Current shares outstanding 3,600 Price /share 25.00 1 a ROE Calculation Economic Condition Normal Strong Expansion Recession EBIT 8,000 9,600 5,600 Equity amount 90,000 90,000 90,000 ROE= 8.89% 10.67% 6.22% b % Change in ROE 20.00% -30.0% 2 ROE after Recapitalization Amt $ Normal Strong Expansion Recession EBIT 8,000 8,000 9,600 5,600 Debt Amount 34,000 Interest on Debt @6% 2,040 2,040 2,040 2,040 Net Earning 5,960 7,560 3,560 Equity amount after repurchase 56,000 56,000 56,000 56,000 a ROE= 10.64% 13.50% 6.36% b % Change in ROE 26.85% -40.27% 3 ROE with Tax a ROE before debt Issue ROE Calculation Economic Condition Normal Strong Expansion Recession EBIT 8,000 9,600 5,600 Less Tax @35% 2,800 3,360 1,960 Net Earning After Tax 5,200 6,240 3,640 Equity amount 90,000 90,000 90,000 ROE= 5.78% 6.93% 4.04% % Change in ROE 20.00% -30.0% b ROE after debt issue ROE after Recapitalization Amt $ Normal Strong Expansion Recession EBIT 8,000 8,000 9,600 5,600 Debt Amount 34,000 Interest on Debt @6% 2,040 2,040 2,040 2,040 EBT 5,960 7,560 3,560 Tax @35% 2,086 2,646 1,246 Net Profit After Tax 3,874 4,914 2,314 Equity amount after repurchase 56,000 56,000 56,000 56,000 ROE= 6.92% 8.78% 4.13% % Change in ROE 26.85% -40.27%
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