*************I POSTED THIS QUESTION EARLIER AND THE ANSWER I RECEIVED WAS INCORR
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*************I POSTED THIS QUESTION EARLIER AND THE ANSWER I RECEIVED WAS INCORRECT. PLEASE ANSWER THE FULL QUESTION!****************
Music City, Inc., has no debt outstanding and a total market value of $240,000. Earnings before interest and taxes, EBIT, are projected to be $28,000 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 25 percent lower. The company is considering a $48,000 debt issue with an interest rate of 4 percent. The proceeds will be used to repurchase shares of stock. There are currently 20,000 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 and 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. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answers as a percent rounded to the nearest whole number, e.g., 32.)
Calculate the return on equity (ROE) under each of the three economic scenarios. (Do not round intermediate calculations and 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. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and 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 and 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. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answers as a percent rounded to the nearest whole number, e.g., 32.)
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 and 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. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
Music City, Inc., has no debt outstanding and a total market value of $240,000. Earnings before interest and taxes, EBIT, are projected to be $28,000 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 25 percent lower. The company is considering a $48,000 debt issue with an interest rate of 4 percent. The proceeds will be used to repurchase shares of stock. There are currently 20,000 shares outstanding. Ignore taxes for questions a and b. Assume the company has a market-to-book ratio of 1.0.
Explanation / Answer
Market Value = Book Value = $ 240,000 (Since, Market to Book = 1.0)
a-1.) Before any debt is issued:
i) Normal condition: Projected EBIT = $28,000
Since there's no debt, interest expense = 0. Ignoring Tax expense, Tax = 0.
Assuming there's no other expenses present (not mentioned in the question), Net Income = EBIT - Interest expense - Tax
Net Income = $28,000
Return on Equity = Net Income / (Average Shareholders equity)
= (28,000 / 240,000) = 0.116667 = 11.67%
ii) Expansion: Projected EBIT = 28,000 * 1.10 = $30,800
Since there's no debt, interest expense = 0. Ignoring Tax expense, Tax = 0.
Net Income = EBIT - Interest expense - Tax
Net Income = $30,800
Return on Equity = Net Income / (Average Shareholders equity)
= (30,800 / 240,000) = 0.128333 = 12.83%
iii) Recession: Projected EBIT = 28,000 * (1-0.25) = $21,000
Since there's no debt, interest expense = 0. Ignoring Tax expense, Tax = 0.
Net Income = EBIT - Interest expense - Tax
Net Income = $21,000
Return on Equity = Net Income / (Average Shareholders equity)
= (21,000 / 240,000) = 0.0875 = 8.75%
To Summarize:
a-2.) Calculate the percentage changes in ROE when the economy expands or enters a recession.
ROE under normal conditions = 0.1167
When the economy expands, ROE = 0.1283
Percentage change when the economy expands = (0.1283 - 0.1167) / (0.1167) = 0.099400 = 9.94%
When the economy enters a recession, ROE = 0.0875
Percentage change when the economy enters recession = (0.0875 - 0.1167) / (0.1167) = -0.25021 = -25.02%
ASSUMING THE FIRM GOES THROUGH RECAPITALIZATION:
The company is considering a $48,000 debt issue with an interest rate of 4 percent.
Interest expense = 4% of 48,000 = $1,920
The proceeds will be used to repurchase shares of stock.
Current shares outstanding: 20,000
Current Share price = (Total Market Value) / Current shares outstanding = (240,000 / 20,000) = $12.00
Assuming, the repurchase is done at the same share price; No. of shares repurchased = ($48,000 / $12) = 4,000
Current shares outstanding post repurchase = (20,000 - 4,000) = 16,000
Market Value = Book Value = 16,000*12 = $192,000
b-1)
i) Normal condition: Projected EBIT = $28,000
interest expense = $1,920 (Calculated above). Ignoring Tax expense, Tax = 0.
Assuming there's no other expenses present (not mentioned in the question), Net Income = EBIT - Interest expense - Tax
Net Income = $28,000 - $1,920 = $26,080
Return on Equity = Net Income / (Average Shareholders equity)
= (26,080 / 192,000) = 0.135833 = 13.58%
ii) Expansion condition: Projected EBIT = $28,000 * 1.1 = $30,800
interest expense = $1,920. Ignoring Tax expense, Tax = 0.
Assuming there's no other expenses present (not mentioned in the question), Net Income = EBIT - Interest expense - Tax
Net Income = $30,800 - $1,920 = $28,880
Return on Equity = Net Income / (Average Shareholders equity)
= (28,880 / 192,000) = 0.150416 = 15.04%
iii) Recession condition: Projected EBIT = $28,000 * 0.75 = $21,000
interest expense = $1,920. Ignoring Tax expense, Tax = 0.
Assuming there's no other expenses present (not mentioned in the question), Net Income = EBIT - Interest expense - Tax
Net Income = $21,000 - $1,920 = $19,080
Return on Equity = Net Income / (Average Shareholders equity)
= (19,080 / 192,000) = 0.09937 = 9.94%
To Summarize:
b-2) Calculate the percentage changes in ROE when the economy expands or enters a recession
ROE under normal conditions = 0.1358
When the economy expands, ROE = 0.1504
Percentage change when the economy expands = (0.1504 - 0.1358) / (0.1358) = 0.10751 = 10.75%
When the economy enters a recession, ROE = 0.09937
Percentage change when the economy enters recession = (0.0994 - 0.1358) / (0.1358) = -0.26804 = -26.80%
ASSUME THE FIRM HAS A TAX RATE OF 35%
Tax expense = EBIT * 35%
Shareholders equity: 240,000 (since there's no debt issued)
c-1) Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued.
i) Normal condition: Projected EBIT = $28,000
Tax expense = 0.35 * 28,000 = $9,800
Assuming there's no other expenses present (not mentioned in the question), Net Income = EBIT - Tax
Net Income = $28,000 - $9,800 = $18,200
Return on Equity = Net Income / (Average Shareholders equity)
= (18,200 / 240,000) = 0.07583 = 7.58%
ii) Expansion condition: Projected EBIT = $28,000 * 1.1 = $30,800
Tax expense = 30,800 * 0.35 = $10,780
Assuming there's no other expenses present (not mentioned in the question), Net Income = EBIT - Tax
Net Income = $30,800 - $10,780 = $20,020
Return on Equity = Net Income / (Average Shareholders equity)
= (20,020 / 240,000) = 0.0834167 = 8.34%
iii) Recession condition: Projected EBIT = $28,000 * 0.75 = $21,000
Tax expense = 21,000 * 0.35 = 7,350.
Assuming there's no other expenses present (not mentioned in the question), Net Income = EBIT - Tax
Net Income = $21,000 - $7,350 = $13,650
Return on Equity = Net Income / (Average Shareholders equity)
= (13,650 / 240,000) = 0.056875 = 5.69%
To Summarize:
c-2.) Calculate the percentage changes in ROE when the economy expands or enters a recession
ROE under normal conditions = 0.0758
When the economy expands, ROE = 0.0834
Percentage change when the economy expands = (0.0834 - 0.0758) / (0.0758) = 0.100263 = 10.02%
When the economy enters a recession, ROE = 0.0569
Percentage change when the economy enters recession = (0.0569 - 0.0758) / (0.0758) = -0.2493 = -24.93%
Economic Condition ROE Recession 8.75% Normal 11.67% Expansion 12.83%Related Questions
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