Question
Kaelea, Inc., has no debt outstanding and a total market value of $110,000. Earnings before interest and taxes, EBIT, are projected to be $8,800 if
Kaelea, Inc., has no debt outstanding and a total market value of $110,000. Earnings before interest and taxes, EBIT, are projected to be $8,800 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. The company is considering a $36,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 4,400 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.
ROE | |
Recession | % |
Normal | % |
Expansion | %
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b. Calculate the percentage changes in ROE when the economy expands or enters a recession, assuming no taxes.
%ROE | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Recession | % | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Expansion | % | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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
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