Question 1 for reference 3. ROE and Leverage. Suppose the company in Problem I h
ID: 2797681 • Letter: Q
Question
Question 1 for reference
3. ROE and Leverage. Suppose the company in Problem I has a market-to- book ratio of 1.0 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, assuming no taxes. Repeat part (a) assuming the firm goes through with the proposed recapitalization. Repeat parts (a) and (b) of this problem assuming the firm has a tax rate of 35 percent. b. c.
Explanation / Answer
Q1
A. EPS before recapitalization
EPS = PAT/No. of Outstanding equity shares
In this case, no taxes or interest so PAT = EBIT
EPS in Normal condition = 13800/7350 = 1.88 per share
Expansion = 13800(1+0.2)/7350 = 16560/7350 = 2.25 per share
Recession = 13800(1-0.35)/7350 = 8970/7350 = 1.22 per share
The percentage changes will be constant with the changes in the EBIT, considering that there are no other variables at play
B. Interest expense = (39750 * 6%)
= $2.385
This interest expense will be reduced from the EBIT to substitute the PAT in this calculation
Normal EPS = (13800-2385)/7350 = 11415/7350 = 1.55 per share
Expansion EPS = 13800(1+0.2)-2385/7350 = 14175/7350 = 1.93 per share or 25% higher
Recession EPS = 13800(1-0.35)-2385/7350 = 6585/7350 = 0.90 per share or 58% lower
Q2.
A.
ROE before recapitalization
ROE = PAT/MV of Equity * 100
Using the EBIT amounts calculated above
Normal ROE = 13800/194775 * 100 = 7.09%
Expansion ROE = 16560/194775 * 100 = 8.50%
Recession ROE = 8970/194775 * 100 = 4.61%
Here as well, like Q1 A, the percentage changes will be the same as the changes in the EBIT.
B.
Normal ROE = 11415/194775 * 100 = 5.86%
Expansion ROE = 14175/194775 * 100 = 7.28% or 24% higher
Recession ROE = 6585/194775 * 100 = 3.38 % or 58% lower
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