Kaelea, Inc., has no debt outstanding and a total market value of $165,000. Earn

Question

Kaelea, Inc., has no debt outstanding and a total market value of $165,000. Earnings before interest and taxes, EBIT, are projected to be $9,900 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 24 percent higher. If there is a recession, then EBIT will be 31 percent lower. The company is considering a $46,500 debt issue with an interest rate of 5 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,500 shares outstanding. Assume the company 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, assuming no taxes. (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

b. Calculate the percentage changes in ROE when the economy expands or enters a recession, assuming no taxes. (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.)

  
Assume the firm goes through with the proposed recapitalization and no taxes.

c. Calculate return on equity, ROE, under each of the three economic scenarios after the recapitalization. (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

d. Calculate the percentage changes in ROE for economic expansion and 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.)

Assume the firm has a tax rate of 40 percent.

e. 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. (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.)

f. 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. (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.)

Explanation / Answer

Market Value 165000 $ EBIT (Normal) 9900 $ 2376 EBIT (Expansion) 12276 $ 3069 EBIT (Recession) 6831 $ Debt issue 46500 $ ROI 5% No. of share 5500 Price per share 30 a ROE Recession 4.14 % (6831/165000)*100 Normal 6.00 % (9900/165000)*100 Expansion 7.44 % (12276/165000)*100 b % change in ROE %ROE Recession -186 % Expansion 144 % c Market-to-book ratio is 1. So Market value of shares and bok value of shares is equal. Also, the company is considering buy back. It buys back at market value i.e. at $30 per share Market value of remaining shares after buyback = 118500 165000-46500 No. of shares bought back = 1550 46500/30 No. of shares after buyback = 3950 5500-1550 ROE Recession 5.76 % (6831/118500)*100 Normal 8.35 % (9900/118500)*100 Expansion 10.36 % (12276/118500)*100 d % change in ROE %ROE Recession -258.99 % Expansion 200.51 % e Tax rate is 40% Tax (Normal) 3960 $ 9900*40% EBIT Post Tax (Normal) 5940 $ 9900-3960 Tax (Expansion) 4910.40 $ 12276*40% EBIT Post Tax (Expansion) 7365.60 $ 12276-4910.40 Tax (Recession) 2732.40 $ 6831*40% EBIT Post Tax (Recession) 4098.60 $ 6831-2732.40 ROE Recession 2.48 % (4098.60/165000)*100 Normal 3.60 % (5940/165000)*100 Expansion 4.46 % (7365.60/165000)*100 % change in ROE %ROE Recession -111.60 % Expansion 86.40 %

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