Problem 14-3 ROE and Leverage

Beckett, Inc., has no debt outstanding and a total market value of $240,000. 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 15 percent higher. If there is a recession, then EBIT will be 30 percent lower. Beckett is considering a $80,000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 15,000 shares outstanding. Ignore taxes for questions a and b. Assume the stock price remains constant.

a-1.	Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places (e.g., 32.16).)

	ROE
Recession	%
Normal	%
Expansion	%

a-2.	Calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent.)

	% change in ROE
Recession	%
Expansion	%

Assume the firm goes through with the proposed recapitalization.

b-1.	Calculate the return on equity (ROE) under each of the three economic scenarios. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places (e.g., 32.16).)

	ROE
Recession	%
Normal	%
Expansion	%

b-2.	Calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations and round your final answers to 2 decimal places (e.g., 32.16).)

	% change in ROE
Recession	%
Expansion	%

Assume the firm has a tax rate of 35 percent.

c-1.	Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places (e.g., 32.16).)

	ROE
Recession	%
Normal	%
Expansion	%

c-2.	Calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent.)

	% change in ROE
Recession	%
Expansion	%

c-3.	Calculate the return on equity (ROE) under each of the three economic scenarios assuming the firm goes through with the recapitalization. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places (e.g., 32.16).)

	ROE
Recession	%
Normal	%
Expansion	%

c-4.	Given the recapitalization, calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places (e.g., 32.16).)

	% change in ROE
Recession	%
Expansion	%