Question
Kaelea, Inc., has no debt outstanding and a total market value of $81,000. Earnings before interest and taxes, EBIT, are projected to be $9,800 if
Kaelea, Inc., has no debt outstanding and a total market value of $81,000. Earnings before interest and taxes, EBIT, are projected to be $9,800 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 23 percent higher. If there is a recession, then EBIT will be 32 percent lower. Kaelea is considering a $23,100 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,400 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.
(b) | Calculate the percentage changes in ROE when the economy expands or enters a recession, assuming no taxes. |
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.
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