Music City, Inc., has no debt outstanding and a total market value of $150,000. Earnings before interest and taxes, EBIT, are projected to be $32,000 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 30 percent lower. The company is considering a $75,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 10,000 shares outstanding. Ignore taxes for questions a and b. Assume the company has a market-to-book ratio of 1.0.

Assume the firm has a tax rate of 35 percent.

a-1. Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued.

Recession?

Normal?

Expansion?

a-2. Calculate the percentage changes in ROE when the economy expands or enters a recession.

Recession?

Expansion?

a-3. Calculate return on equity (ROE) under each of the three economic scenarios assuming the firm goes through with the recapitalization.

Recession?

Normal?

Expansion?

a-4. Given recapitalization, calculate the percentage changes in ROE when the economy expands or enters a recession.

Recession?

Expansion?